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Restoring the lustre of the European economic model INDERMIT S GILL MARTIN RAISER

GOVERNMENT LABOR INNOVATION ENTERPRISE FINANCE TRADE


CHAPTER 5

Chapter 5 Innovation Google did not exist in 1995. Today, its market value is about $150 billion. Google’s story epitomizes the success of the American “innovation machine.” In 1999, roughly a third of the world’s 1,000 largest firms by market capitalization were based in the United States, and of these, 35 percent were founded after 1950. Europe had only 181 firms among the 1,000 largest, and of these, only 14 percent were founded after 1950 (Cohen and Lorenzi 2000). Europe is a “convergence machine” but not an innovation machine. Over the past 15 years, with a few exceptions in the north, Europe has started falling behind the United States in productivity growth (see spotlight one). Europe’s most successful companies seem to grow by doing what they are already doing—but better. Following the slogan of the German car manufacturer Audi— Vorsprung durch Technik (Leading through Technology)—they have developed evermore efficient versions of traditional technology hits. But European companies have not shifted to radically new technologies, especially information and communications technologies (ICT). As the Google success story unfolded, another was in the making in tiny Estonia. In 2003, four Estonian programmers, along with a Swedish and a Danish entrepreneur, founded Skype.1 A U.S. venture capital firm, Draper and Company, provided seed capital and further investments before eBay took over the company in 2005. Despite ups and downs and disputes among the founders and subsequent owners, the company was sold for $8.5 billion to Microsoft in 2011. Skype’s success demonstrates that Europe can produce young, innovative companies. But the average productivity gap between Europe and the United States will likely persist until Europe’s larger continental economies emulate their intrepid northern neighbors in innovative enterprises. Europe’s most successful new entrepreneurs are small: while Europe does produce internationally competitive innovators in niche markets, the United States dominates among the world’s leading innovators, and this has Europewide effects.

How much does Europe’s innovation deficit matter? Why does Europe do less R&D than the United States, Japan, and the Republic of Korea? What are the special attributes of a successful European innovation system? What should European governments do to increase innovation? 245


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This chapter asks whether Europe has fundamental flaws in its economic environment that make its innovation deficit a fact of life. It looks at both the degree of innovative activities and the way innovative firms grow. In dimensions important for innovation, such as the availability of venture capital funding for European innovators, the business orientation of scientific research, and the share of people with tertiary education, Europe lags the United States. Denmark, Finland, Germany, Sweden, and Switzerland have been building strong national innovation systems that go toe-to-toe with the best in North America and East Asia, suggesting that there are other factors holding Europe’s leading innovators back from growing to a global scale. One big obstacle is Europe’s fragmented internal market for services. Until Europe realizes the gains from market integration and continentwide competition, it is unlikely that enterprises in innovation-intensive sectors such as ICT will match the growth of U.S. enterprises like Amazon, Apple, Facebook, Google, and Microsoft. In analyzing Europe’s innovation performance and comparing it with Europe’s peers in America and Asia, this chapter answers four questions: · How much does Europe’s innovation deficit matter? The innovation deficit explains why Europe has lagged the United States in productivity growth since the mid-1990s—but it is not the only factor. Using various measures of innovation, such as research and development (R&D), patent registration, and the introduction of new products and processes, this chapter shows that these measures correlate with the rate of productivity growth across both countries and firms. But the relationship is complex. Productivity growth depends on firms’ performance at the frontier as well as below it. Having leading innovators in fast-developing sectors, as the United States does, is important to push out the technological frontier. For companies below the frontier and for Europe’s lagging economies, lifting barriers to general investment and human capital formation may be as important as reducing barriers specific to innovation. · Why does Europe as a whole do less R&D than the United States, Japan, and the Republic of Korea? The short answer is that Europe has fewer innovators in sectors that require a lot of investment in R&D. Otherwise identical enterprises are as likely to engage in R&D in Europe as they are in other advanced countries, but in Europe leading innovators are less likely to engage in R&D-intensive sectors like biotech and the Internet. So, what keeps entrepreneurs from venturing into new activities? While this chapter offers no definite answer, it suggests that one reason may be the lack of an integrated market for digital services, which leads Europe’s entrepreneurs to benefit less from clustering together than their peers in Silicon Valley or Tokyo. · What are the special attributes of a successful European innovation system? Successful European economies—Denmark, Finland, Germany, Sweden, and Switzerland—have essentially downloaded the “killer apps” that have made the United States a powerhouse for innovation. The apps include incentives for enterprise-based private R&D, an abundant supply of workers with tertiary education, and public funding mechanisms and intellectual property regimes that foster links between universities and firms. But Europe’s leaders are constrained by their market’s small size and incomplete integration.

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Box 5.1: Google—a uniquely American innovation Europe wonders what it takes to raise fast growers. The story of Google’s birth and growth is instructive. Google began as part of a project at Stanford University on investigating the technological requirements for a single, universal digital library. The project was funded by U.S. federal government agencies, including the National Science Foundation. A Stanford Ph.D. student, Larry Page, had the insight that a better search engine—using the analogy of academic citations—would rank web pages by the number of times they were linked to other web pages, rather than how many times the searched word or phrase appears on a web page. He was encouraged to follow this line of inquiry by his supervisor, Terry Winograd, and was joined by another graduate student, Sergey Brin. By 1998, with a $100,000 contribution from Andy Bechtolsheim of nearby Sun Microsystems, Google Inc. was operating out of a Menlo Park garage. The next year, it got $25 million in equity funding from venture capital firms who, by 2001, forced it to hire a CEO. Three years later, in August 2004, with help from Morgan Stanley and Credit Suisse

First Boston, Google went public, raising $1.67 • Second, financial support from the U.S. billion in its initial public offering. In 2005, government for such projects as the Google was valued at more than $50 billion, Stanford Digital Library Project. The National making it one of the world’s largest media Science Foundation is a major supporter of companies, allowing Google to raise $3.5 billion innovation in U.S. universities, as are other in the stock market to acquire complementary federal agencies such as the departments businesses and technologies. In 2006, Google of Commerce, Defense, Energy, and became one of Standard and Poor’s 500 Index. Transportation. The same year, Merriam-Webster and Oxford • Third, proximity to investors who specialize dictionaries officially added “google” as a verb. in information technology ventures—who Besides the ideas and technical expertise of take a chance on new ideas and enterprises its two founders, Google’s success is the result and provide management oversight. A of an unparalleled environment for innovation culture of risk-taking and a tolerance for in information technology. Its four main failure provides a conducive climate for such attributes are these: long shots as Google. • First, universities that—through close links to firms—start and nurture the agglomeration of expertise and enterprise. In this case, the university is Stanford, and the agglomeration is Silicon Valley in the San Francisco peninsula, which radiates outward from the university. The university itself, founded privately in 1891, helped create Silicon Valley by leasing land to entrepreneurs, and then by providing human capital. Close to half of Silicon Valley firms are started by Stanford alumni.

• Fourth, the ability to attract global talent. Bechtolsheim grew up in Germany before coming to the United States on a Fulbright scholarship, and he stayed on after his studies. Had he returned, he might not have been worth $2 billion, and Page and Brin might not have received a big check to get started.

Source: Google.

· What can European governments do to increase innovation where it is most needed? The answer is a two-pronged approach. First, reform the innovation ecosystem—regulations, finance, science, and incentives—to ease entry and reward risk-taking. Second, increase the size of the market for European innovators by strengthening the single market for digital and other modern services, which would allow agglomeration. Google’s success provides some clues about priorities and payoffs (box 5.1). The most important may be that to compete with the United States, Japan, and soon China, Europe has to bring together academic intellect, public funding, and private finance on a European scale.

Europe’s innovation deficits matter—but not equally for everyone In 1950–73, the Golden Age of European growth, productivity in Western and Eastern Europe converged rapidly toward that in the United States, the world’s leading industrial economy. Growth and income convergence slowed over 1973–95, but for productivity it continued, as European working hours fell to less than those of the United States. During this period, the cohesion countries of Southern Europe and Ireland caught up rapidly with the European Union’s founding members. Since 1995, the “old” EU members (EU15) have recorded slower productivity growth than the United States and have essentially stopped converging, while the new member

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Figure 5.1: Mind the gap: convergence followed by slowdown in Europe’s productivity relative to the United States (GDP per hours worked in Geary/ Khamis $, United States = 100)

Note: EU15 North = Denmark, Finland, Sweden, and the United Kingdom; EU15 Continental = Austria, Belgium, France, Germany, and the Netherlands; EU15 South = Greece, Italy, Portugal, and Spain. Source: World Bank staff calculations, based on Conference Board 2011.

states in Eastern Europe have started to catch up rapidly. As chapter 4 shows, productivity growth in Europe’s south has been especially disappointing since 1995, while the north kept pace with the United States until the crisis (spotlight one; figure 5.1).2

Innovation as a source of long-term growth differentials Innovation as a driver of long-term productivity growth has contributed to the EU15’s failure to close its productivity gap with the United States. Economists have long linked long-term growth to technological improvements (for example, Solow 1956), but how technology improved remained a black box. More recently, Romer (1990) and Aghion and Howitt (1992 and 1998) proposed theories that link an economy’s growth rate to its innovation rate. Aghion and Howitt’s theory is of particular interest, because it accounts for empirical phenomena that characterize economic growth and convergence in Europe (Aghion and Howitt 2006): · Productivity growth results from improvements in product quality, as firms that innovate substitute old, obsolete production with new, better-quality production. This “creative destruction,” described first by Joseph Schumpeter, has led to accelerated structural change and productivity catch-up in Eastern Europe (Alam and others 2008). · Firms innovate both by pushing out the technological frontier and by adapting technologies from the stock of global knowledge. As the stock grows, so too do the returns to innovation for all technological followers. Innovation has positive spillovers that can account for long-term growth differentials among economies. The European Union has targeted an increase in R&D investments as a key policy variable for improving long-term growth prospects. · The forces driving innovation at or below the frontier differ. Competition spurs firms at the frontier to innovate to “escape” competitors, but for firms

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well below the frontier, competition may discourage technological adaptation, because it reduces the rents available from adapting better technologies.3 As a result, policies to promote productivity growth through innovation depend on whether a country’s firms are below or at the technological frontier. For instance, comprehensive secondary education may be critical during catch-up, but tertiary education acquires greater weight once a country has reached the frontier; bank-led relationship-based financing may be optimal during catch-up, but for innovation at the frontier, equity (or venture capital) financing is likely better suited. Europe moved from below the frontier in the period of rapid convergence to close to it by the mid-1990s, and therefore the same policies that were good for growth before may not be optimal now (Abramovitz 1986; Eichengreen and Vazquez 2000; Aghion and Howitt 2006). Considerable empirical literature supports the importance of structural change and innovation for productivity growth. Van Ark, O’Mahony, and Timmer (2008) decomposed economic growth in the United States and Europe into the contribution of several inputs to understand the productivity gap between the United States and the EU15 since 1995. The authors find that the key factor is the different rate of multifactor productivity growth in market services, such as retail trade, finance, and business.4 Jorgenson and Timmer (2011) further show that the United States has benefited from much faster total factor productivity (TFP) growth in distribution and personal services than has the European Union. While the different rate of investment in ICT made a small contribution, organizational changes and product and process innovation in services—rather than capital deepening as a result of the introduction of ICT—lie behind the divergence in performance between the United States and Europe. In short, the United States gets a bigger productivity kick out of ICT than does Europe. In addition, vast empirical literature investigates innovation’s role in productivity and growth across enterprises or sectors of an economy. Hall, Mairesse, and Mohnen (2009) and Hall (2011) estimate the return on investments in R&D from those that link innovation to productivity growth through qualitative measures of product and process innovation (see box 5.2 for definitions of the various forms of innovation). The distinction is important because measures of investment in innovation, such as R&D spending, might not fully capture the nature of innovation in service industries such as retail or finance, which have been important in driving productivity growth differences between Europe and the United States. The conclusion from the empirical literature confirms the intuition behind recent

Box 5.2: Defining innovation • Innovation: The development and commercialization of products and processes that are new to the firm, the market, or the world. Activities involved range from identifying problems and generating new ideas and solutions to implementing those solutions and diffusing new technologies.

• Product innovation: The development of new products representing discrete improvements over existing ones. • Process innovation: The implementation of a new or greatly improved production or delivery method, or of a new organizational method in firms’ business practices, workplace organization, or external relations. This includes “soft innovation,”

such as layout reorganization, transport modes, management, and human resources. • Incremental innovation: Innovation that builds closely on technological antecedents and does not involve much technological improvement upon them. Source: Goldberg and others (2011), based on the Organisation for Economic Co-operation and Development.

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Figure 5.2: Europe has a large innovation deficit relative to both the United States and East Asia’s high-income economies (R&D expenditures as share of economic output of selected countries, 2000–08)

Note: Europe includes the EU27, EFTA, and EU candidate countries. Source: UNESCO.

endogenous growth literature: innovation is positively associated with higher firm productivity and growth, and the social rate of return on innovation exceeds the private rate of return because of positive spillovers from growth in the available stock of knowledge.5

How large is Europe’s innovation deficit? Given the role of innovation in productivity growth, how does Europe measure up? Comparing the share of R&D investment in GDP in Europe with that in the United States and East Asia’s high-income economies, Europe as a whole does less R&D (figure 5.2). Moreover, China has increased its R&D investment rapidly over the past decade, closing the gap with the EU15 and exceeding the new member states (EU12), EU candidate countries, and European partnership states. As chapter 1 shows, Europe’s gap in R&D investments is due entirely to the lower R&D investments of Europe’s business sector. Aggregate comparisons, however, may be misleading. Innovative activity varies across European countries, and a wider range of indicators depicts a more varied landscape than a simple comparison of aggregate investment rates in R&D. One recent comparative data collection effort is the Innovation Union Scoreboard (IUS) prepared by the European Commission (European Commission 2011b), which compares innovation efforts across countries in Europe and is benchmarked against the United States and Japan.6 R&D investments and patent counts are the measures of innovation used most in enterprise-level studies linking innovation with productivity (Hall, Mairesse, and Mohnen 2009; figure 5.3). The leading countries in business investment in R&D are also the leading countries in patent counts.7 Europe’s leaders in both fields perform as well as or better than the United States and Japan.8 The data on public R&D investments and international revenues from patents and licenses present a less clear pattern. Austria, France, the Netherlands, and

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Figure 5.3: Europe’s leaders invest as much in innovation as the United States and Japan (business and public R&D expenditure, percentage of GDP)

(patent counts and revenues from international licenses and patents)

Note: Data refer to different years by country. Source: European Commission 2011b; UNESCO; and IMF BOPS.

Norway are among Europe’s leaders and have higher spending on public R&D than do the United States or Japan. License and patent revenues from abroad show a diverse pattern, with the Benelux, Hungary, Ireland, Malta, and the United Kingdom performing well alongside Japan, Switzerland, Scandinavia, and the United States. Overall, these four measures are highly correlated: the correlation coefficient between a country’s business and public R&D investment is 0.71, between a country’s business R&D investment and its international patent count is 0.91, and between business R&D investment and international license and patent revenues is still 0.63. The European Commission also collects data for non-R&D innovation spending, as well as the share of companies undertaking product, process, and organizational innovation. These data are collected only for European countries. Non-R&D innovation spending is high in Europe’s emerging economies, such as Bulgaria, Croatia, Estonia, Poland, and Romania (figure 5.4).9 Interpretations are speculative, but one possibility is that firms in emerging economies, particularly in the

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Figure 5.4: In Europe’s catching-up economies innovation is not always R&D (non-R&D innovation expenditure, percentage of turnover of all enterprises)

Note: Data refer to different years by country. Source: European Commission 2011b.

transition economies of the former Soviet bloc, now are trying harder to adapt advanced technologies to local circumstances. The Community Innovation Survey collects data on the share of companies undertaking innovative activities, measuring countries’ share of all companies undertaking some kind of innovation, collaborating with partners outside Europe (China, India, and the United States), and collaborating with other companies or research institutions as opposed to doing it in-house (table 5.1). The survey measures collaboration with other companies to gauge the extent of innovation spillovers within and outside Europe. Several observations follow from looking at this survey alongside parallel data on small and medium enterprises (SMEs) (from the IUS but also based on Community Innovation Survey data). There is a high correlation between the overall share of companies innovating and the share of SMEs innovating (0.85). The country with the largest share of companies innovating overall is Germany (close to 80 percent). The lowest proportion of innovating companies, as well as innovating SMEs, is in the transition economies of Eastern Europe: Latvia, Poland, Hungary, Lithuania, Bulgaria, and Romania. There is also a close correlation between the share of companies undergoing process and product innovation and the share undertaking marketing and organizational innovation (0.79). As Hall (2011) summarizes, at the firm level, distinguishing the type of innovation is important, because firms may have different effects on productivity. At the country level, the data suggest countries that have innovative firms tend to have more of innovation overall. The share of companies collaborating with others is also consistent across all firms and the subpopulation of SMEs (correlation of 0.81). Top performers are the United Kingdom, Denmark, Belgium, Estonia, and Slovenia. The least cooperation takes place in Romania, Latvia, and Bulgaria.10 German and Italian companies are far less likely to cooperate and consequently appear to be doing most of their innovation in-house. When looking at where companies’ partners are located, a distinct group of countries emerges that cooperate more internationally than others. This group includes Finland and Sweden as

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Table 5.1: A large share of companies in Europe innovate, less so in the east SMEs innovating in-house

Innovative SMEs collaborating with others

Total innovating SMEs

SMEs introducing product or process innovation

SMEs introducing marketing/ organizational innovation

Total share of innovating enterprises

All types of cooperation

Cooperation with United States

Cooperation with China and India

CIS

CIS

IUS

IUS

IUS

IUS

IUS

CIS

CIS

Denmark

40.8

22.7

63.5

37.6

40.0

51.9

56.8

Finland

38.6

15.3

53.9

41.8

31.5

52.2

36.9

11.1

6.7

Ireland

38.8

9.8

48.6

27.3

41.6

56.5

24.1

2.5

2.8

Sweden

37.0

16.5

53.5

40.6

36.7

53.7

39.9

11.2

7.3

25.1

31.1

45.6

United Kingdom

25.0

EU15 North

38.8

17.9

54.9

34.5

36.2

52.0

39.4

8.3

5.6

Austria

34.4

14.7

49.1

39.6

42.8

56.2

38.8

3.1

1.8

Belgium

40.2

22.2

62.5

44.0

44.1

58.1

48.8

9.4

5.8

France

30.0

13.5

43.5

32.1

38.5

50.2

42.4

5.2

2.4

Germany

46.0

9.0

55.0

53.6

68.2

79.9

20.7

2.4

1.3

Luxembourg

37.4

12.3

49.7

41.5

53.0

64.7

30.1

8.7

3.7

Netherlands

26.3

13.0

39.2

31.6

28.6

44.9

40.2

7.4

3.1

EU15 Continental

35.7

14.1

49.8

40.4

45.9

59.0

36.8

6.0

3.0

Greece

32.7

13.3

46.0

37.3

51.3

Italy

34.1

6.0

40.1

36.9

40.6

53.2

16.2

1.3

0.8

Portugal

34.1

13.3

47.4

47.7

43.8

57.8

28.4

1.8

1.1

Spain

22.1

5.3

27.4

27.5

30.4

43.5

18.7

1.0

0.4

EU15 South

30.8

9.5

40.2

37.4

41.5

51.5

21.1

1.4

0.8

Bulgaria

17.1

3.5

20.6

20.7

17.4

30.8

16.6

1.1

0.5

Cyprus

41.6

21.3

62.9

42.2

47.3

56.1

51.4

3.6

3.2

Czech Republic

29.6

11.3

40.9

34.9

45.9

56.0

32.9

2.8

2.0

Estonia

34.0

22.3

56.3

43.9

34.1

56.4

48.6

2.7

1.4

Hungary

12.6

7.2

19.8

16.8

20.5

28.9

41.3

3.1

2.7

Latvia

14.4

3.3

17.7

17.2

14.0

24.3

16.6

1.2

0.1

Lithuania

19.4

8.0

27.4

21.9

21.4

30.3

38.7

4.5

2.6

Malta

21.6

5.2

26.8

25.9

25.6

37.4

19.8

3.1

2.0

Poland

13.8

6.4

20.2

17.6

18.7

27.9

39.3

4.2

2.0

Romania

16.7

2.3

18.9

18.0

25.8

33.3

13.8

1.4

0.8

Slovak Republic

15.0

5.8

20.7

19.0

28.3

36.1

32.2

4.0

3.5

Slovenia EU12

14.2 21.4

Iceland

9.2

31.0

39.4

50.3

48.0

6.6

4.1

30.2

25.8

28.2

39.0

33.3

3.2

2.1

30.8

49.2

35.1

4.3

2.2

14.1

Norway

25.4

13.1

38.5

28.9

Switzerland

28.2

9.4

37.6

57.0

EFTA

26.8

12.2

38.1

43.0

30.8

49.2

35.1

4.3

2.2

Croatia

25.6

11.9

37.5

31.5

32.5

44.2

38.1

2.3

1.1

44.2

38.1

2.3

1.1

Macedonia, FYR

11.3

9.6

20.9

39.2

30.8

Serbia

27.8

3.5

31.3

18.3

18.1

Turkey

28.2

5.3

33.5

29.5

50.3

EU candidates

23.2

7.6

30.8

29.6

32.9

Note: Data refer to different years by country and data source. Source: European Commission 2011b; and sixth Community Innovation Survey (CIS).

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leading international cooperators, but also the Benelux, Slovenia, and—to less extent—France. The United Kingdom does not report which countries its firms collaborate with, but likely belongs with this group. In sum, there appears to be a group of leading innovators in Europe, distinguished by sizable investments in business R&D, a strong record in international patent registrations, and a substantial proportion of companies that undertake one type of innovation or another. This group does not have an innovation deficit relative to the United States or Japan, though it still lags behind the United States in productivity, particularly in services. Many other European countries do, however, have an innovation gap. Among the top performers in Europe, there is a distinct difference between the pattern in Germany—with many firms innovating mostly in-house—and the pattern in Scandinavia or the Benelux, where there is a stronger propensity for firms to innovate through collaboration with other companies or research institutes. Europe’s emerging economies in the east are lagging behind on most indicators of innovation (with some notable exceptions such as Slovenia and Estonia) except for investments in non-R&D-related innovation.

The North innovates more than others; in the East investment matters more Do these patterns help to explain the strong economic performance of Europe’s northern economies relative to the less impressive performance in the south, as demonstrated in chapter 4? And how can we account for strong productivity growth in Eastern Europe, given that most transition economies do not seem to invest a lot in innovation or have a large share of innovative firms? The answer to the first question is to some extent. The answer to the second is that innovation is only one input into the productivity of firms, and the rate of return on innovation investments varies not only across companies but also across countries.

Figure 5.5: Innovation: another north-south gap in Europe

Note: Data are normalized to lie between zero (worst) and one (best) and refer to different years by country. Source: European Commission 2011b; sixth Community Innovation Survey (CIS); UNESCO; IMF BOPS.

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A word of caution: this chapter makes no attempt at a robust growth-accounting exercise that would allow the contribution of country-level innovation to be disentangled from other factors such as investments in physical and human capital. We undertake two simple exercises. The first shows the average scores by geographical country groups across all indicators used to measure innovation in figures 5.2 and 5.3 and table 5.1 (figure 5.5). The country groups are the same as used in chapter 4: the EU15 split into a northern group (Ireland, Scandinavia, and the United Kingdom), a continental group (Austria, Benelux, France, and Germany), and a southern group (Greece, Italy, Portugal, and Spain), and all of the new EU member or candidate countries in the sample (not distinguished here between subgroups among the emerging European countries). These scores tell a clear story: across most innovation measures the southern group lags the northern and the continental (figure 5.5). The only exception is the share of SMEs that introduce product and process innovation or marketing and organizational innovation. The emerging economies in Eastern Europe score poorly on most dimensions of innovation, despite their strong productivity growth record, though they outperform the south in the share of enterprises cooperating with others inside and outside Europe and in non-R&D spending. The second simple exercise correlates the measures of innovation introduced above with a measure of TFP, drawn on the ECFIN-AMECO database for TFP calculations available annually for 1998–2008 (figure 5.6).11 In the EU15, there is a clear positive correlation between TFP growth and two of the three measures of innovation in figure 5.6: business R&D and registered international patents. The total share of firms innovating is not correlated with TFP growth in the EU15. In the EU12, the correlation between innovation and TFP growth is slightly negative. In other words, while innovation matters, it matters much more in “old” Europe than in “new” Europe to explain differences in productivity growth.12 In sum, there is no single innovation and productivity gap between Europe and the United States. Europe’s leading innovators in the north (and to less extent, the continental countries) have kept pace with U.S. productivity growth and seem

Figure 5.6: Innovation matters much more in “old” Europe than in “new” Europe in explaining differences in productivity growth (innovation and TFP growth—different patterns in east and west)

Note: Business R&D is expressed as percentage of GDP and registered patents refer to patent applications per billions of GDP in euro. Data refer to different years by country and indicator. Source: World Bank staff calculations, based on European Commission 2011b; and European Commission’s annual macro-economic database (AMECO).

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to be matching U.S. innovative investment and activity. For these countries, the question is how to become global productivity leaders. Europe’s south innovates less and has fallen behind in productivity. These countries have an innovation and productivity gap to close with their Northern and Continental European peers and with the United States. Europe’s east is catching up in productivity, but remains far behind in innovation. For these countries, sustaining productivity growth is what matters, but the innovation gap so far has not been a binding constraint. Evidence from other emerging markets confirms that returns on innovation vary in relation to both the stock of complementary investments in physical and human capital (box 5.3) and a country’s position relative to the global technological frontier (box 5.4). Chapter 4 analyzed the variation in enterprise performance in relation to a wider range of factors, including the business climate, the availability of skills, the quality of a country’s infrastructure, and

Box 5.3: Is R&D/GDP a good measure of innovation performance? It is common to rank innovation performance by the share of R&D investment in GDP. But intuitively it cannot be true that, given huge differences in the sophistication of the private sector, the optimal level of investment in R&D should be the same in Albania and Germany. Generally, the question is whether countries face a barrier to accumulating knowledge capital, or to all factors of production. To approach the question of whether Latin America showed innovation shortfalls, Maloney and Rodríguez-Clare (2007) used a model developed and calibrated by Klenow and Rodríguez-Clare (2005) that allows for both types of barriers and captures

interactions in accumulating different types of capital, including “knowledge capital.” To extend this to additional countries, we compare the conventional measure of R&D investment (box figure 1, vertical axis) with the degree to which, controlling for other factors of production, it appears that innovation is inhibited (taxed) or, if to the left of the origin, subsidized (box figure 1, horizontal axis). Although the analysis depends on notoriously fickle measures of relative TFP, it suggests several interesting findings. For instance, even though China is far above Colombia in R&D spending, the analysis suggests that it could

invest more given the accumulation of human and physical capital. But Hong Kong SAR, China—below China in R&D spending—appears to be innovating more than expected given the other factors accumulated; it may not be efficient to push toward a higher share of R&D. The analysis is only suggestive, but it makes an important point: innovation does not exist independent of other factors of production. When barriers to accumulation are high and binding, additional R&D spending may yield few benefits. Source: World Bank staff, based on Maloney and Rodríguez-Clare 2007.

Box figure 1: R&D level may not show innovation problem 2.50%

R&D Expenditure (%GDP)

Korea

2.00%

Taiwan

1.50%

New Zealand

1.00%

Brazil

South Africa

0.50%

China

India Chile

Hong Kong Malaysia

Mexico Argentina

Colombia

0.00% -200%

-100%

0%

100%

200%

300%

400%

Tax on Innovation

Note: R&D expenditure (percentage of GDP) is average for 1995–99. Tax on innovation is the calibration of the model by Maloney and Rodríguez-Clare (2007), adjusting for natural resources activities. The calibration is done using data for the 1990s, except for Hong Kong SAR, China (1980s). Source: World Bank staff calculations, based on WDI; statistical yearbook (Taiwan, China); and UNESCO (South Africa).

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others. When these factors are binding, innovation may matter less. Comparing Europe’s leading innovating companies with those in the United States and Japan, how does Europe perform “at the frontier”?

Why European enterprises do less R&D—not enough Yollies If Europe’s most innovative countries invest as heavily in R&D as the United States and Japan, comparing favorably with these peers on innovation indicators, why don’t we find Googles and Apples in Sweden and Finland? One answer is that Europe’s leading innovators are mostly older companies operating in less innovationintensive sectors. Europe struggles to nurture young, innovative companies in sectors characteristic of the “new” economy, such as ICT, biotechnologies, or medical services, which would grow into global leaders. Europe’s leading innovators are more Box 5.4: Why don’t lagging countries do more R&D? Although R&D spending is associated with inventions at the frontier, Cohen and Levinthal (1989) stress the “second face” of R&D, which facilitates the adoption of existing technologies from abroad. Griffith, Redding, and Van Reenen (2004) test this using sectoral time series data from 11 OECD countries. They find that countries further from the frontier had rates of return almost twice those at the frontier. For instance, the United States had a total rate of return of 57 percent while Finland and Norway had rates of return close to 100 percent, with 50 percent due to enhanced learning. These numbers are extraordinarily high, but not necessarily out of line with those found in other studies (see Jones and Williams 1998, and Hall, Mairesse, and Mohnen 2009). Jones and Williams (1998) calculate that at these returns, the United States should be investing roughly four times what it does

presently. The question arises, if returns increase as we get further from the frontier, why would lagging countries invest in anything besides R&D? Shouldn’t the southern and eastern countries of Europe invest more than those at the frontier? Using a country-level panel, Goñi, Lederman, and Maloney (2011) confirm previous findings that, up to a point, returns rise with distance from the frontier (box figure 1). Each point corresponds to a distance from the frontier represented by a particular country in a particular five-year period, though the estimates, based on a rolling window, do not correspond to that particular country-time combination per se. To the right, we see rich countries with returns consistent with the literature, and then as we move left and away from the frontier to countries such as the Republic of Korea and Greece in 1996–2000,

the returns rise. Beyond the distance corresponding to Mexico, Chile, and Hungary in 1996–2000, returns begin to fall. At Romania’s distance from the frontier, countries actually experience negative returns to R&D. Perhaps the finance minister of Romania is reasonable not to see a 3-percent-of-GDP target as a good use of his resources. Why is this the case? As we get further from the frontier, the business climate is likely to worsen and the private sector become less sophisticated, such that even the best of ideas will yield limited fruit. Moreover, progressively weaker human capital in both the public and private sector could imply few good ideas that actually result from R&D investments. To the degree that they displace more feasible investments in education or infrastructure, the overall return on R&D could be negative.

Box figure 1: Rate of return on R&D versus distance from the frontier

Source: Goñi, Lederman, and Maloney 2011.

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likely to push out the technological frontier in established sectors by developing better-quality versions of the same basic product. But they are less likely than their American counterparts to push into new fields. A word of caution: this section does not directly examine the link between the presence of young, leading innovators and economywide productivity growth. However, the basic argument linking productivity and innovation to the age, size, and sectoral structure of an economy has received significant empirical support (O’Sullivan 2007; Aghion and others 2008). Bartelsman, Haltiwanger, and Scarpetta (2004) found, for instance, that postentry performance differs markedly between Europe and the United States, suggesting barriers to firm growth as opposed to barriers to entry. New European firms’ inability to grow large manifests in the high-tech, high-growth sectors, most notably the ICT sector (Cohen and Lorenzi 2000).13 This correlates with a lower specialization of the European economy in R&D-intensive, high-growth sectors, most notably the ICT sectors (O’Mahony and van Ark 2003; Denis and others 2005; Moncada-Paternó-Castello and others 2010). The global expenditures of leading innovators by age cohort and sector, taken from the JRC-EC-IPTS Industrial R&D Scoreboard (Hernández Guevara and others 2008), demonstrates Europe’s lower rate of investment in R&D compared with the United States. Comparing the innovative profile of young, leading innovators (which we will call “Yollies”) with that of old, leading innovators (“Ollies”) shows how the lower share of Yollies contributes to Europe’s lagging business innovation performance.14

Europe has fewer Yollies than the United States, and its Yollies invest less in R&D Among the United States’ leading innovators in the Industrial R&D Scoreboard, more than half are “young” (born after 1975; figure 5.7). U.S. Yollies include Microsoft, Cisco, Amgen, Oracle, Google, Sun, Qualcomm, Apple, Genzyme, and eBay. By contrast, only one in five leading innovators in Europe is “young.” In the United States, Yollies account for 35 percent of total R&D of leading innovators; in Europe, a mere 7 percent! Notably, Japan has almost no young firms among its leading innovators. The remaining firms in the sample of leading innovators (mostly from emerging Asia) have a high share of young firms, to be expected given the recent economic take-off of these countries. Of the 74 European Yollies in the Scoreboard, 20 are based in the United Kingdom. France, Germany, and Switzerland each hold nine, the Netherlands has eight.15 In relative terms, when looking at the share of Yollies in a country’s total R&D of leading innovators, Italy does poorest with only 3 percent, but Germany and Sweden have surprisingly low shares at 4 percent, way below the European average. The Netherlands, with 15 percent, is above average. Switzerland scores highest in Europe with 24 percent. But even this share is far below the United States’ 35 percent. European Yollies include U.K.-based Vodafone in telecom services, UK Shire in specialty biopharma, Swedish Hexagon in measuring technologies, Dutch ASML in semiconductors, and French Ubisoft in entertainment software.

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Figure 5.7: The role of Yollies among leading innovators is bigger in the United States than in Europe or Japan

Figure 5.8: Yollies spend the most on R&D and U.S. Yollies are the most R&D-intensive of all firms

(percentage of young firms in leading innovators, 2007)

(R&D intensity, percent, 2007)

Note: The total numbers of firms in the sample are in parentheses. Source: Bruegel and World Bank staff calculations, based on European Commission’s IPTS R&D Scoreboard.

Note: R&D intensity is defined as R&D to total sales ratio. Source: Bruegel and World Bank staff calculations, based on European Commission’s IPTS R&D Scoreboard.

The share of Yollies in R&D is higher than in net sales, indicating that Yollies have a higher R&D intensity than their older counterparts (figures 5.7 and 5.8). Once again, the United States stands out, with the highest relative R&D intensity of its Yollies. While on average, Yollies are about twice as R&D-intensive as Ollies, for the United States this ratio stands at almost 3. And for Europe, it is only 1.5. U.S. Yollies are by far the most R&D-intensive firms. Moreover, the gap between the United States and Europe in R&D intensity is larger for Yollies (57 percent) than for Ollies (20 percent). Compared with their U.S. and European counterparts, Yollies from Japan and the rest of the world are less R&D-intensive. Not only does Japan have far fewer Yollies, but its Ollies are more R&D-intensive than its Yollies. This is a remarkable difference from the United States pattern, considering that Japan has just as high a share of business R&D in GDP as the United States. Japanese companies such as Toyota and Sony have retained global leadership through heavy investments in product and process innovation, while maintaining core focus areas. To some extent, the same can be said of firms in Europe’s export champion, Germany. While the United States has Amazon, eBay, Google, and Microsoft, Japan has Toyota and Germany has BMW and Mercedes Benz. Germany’s success relies on consumers in emerging markets who aspire to traditional quality consumer durables from Germany, and investors who prefer German machine tools. For Europe as a whole, as for Japan, the lack of Yollies does, however, reflect lower structural flexibility, reducing its economic competitiveness. Three facts explain the lower overall R&D intensity of Europe’s leading innovators: · Europe has fewer Yollies than the United States, which matters because Yollies have higher R&D intensity than Ollies. · Europe’s Yollies are less R&D-intensive than their U.S. counterparts. · Europe’s Ollies are less R&D-intensive than their U.S. counterparts, though to a lesser extent than its Yollies.

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Table 5.2: Europe specializes in sectors with medium R&D intensity, the United States in high intensity (relative technological advantage (RTA) indices by sector, ratio, 2007) Europe

United States

Aerospace and defense

1.50

1.13

Automobiles and parts

1.26

0.58

Biotechnology

0.32

2.20

Chemicals

1.31

0.64

Commercial vehicles and trucks

1.30

1.06

Computer hardware and services

0.08

1.39

Electrical components and equipment

1.56

0.18

Electronic equipment and electronic office equipment

0.18

0.37

Fixed and mobile telecommunications

1.53

0.20

Food, beverages, and tobacco

0.92

0.74

General industrials

0.61

1.49

Health care equipment and services

0.70

1.86

Household goods

0.84

1.60

Industrial machinery

1.84

0.24

Industrial metals

1.00

0.30

Internet

0.00

2.54

Oil

1.00

0.85

Personal goods

1.44

0.69

Pharmaceuticals

1.27

1.16

Semiconductors

0.50

1.72

Software

0.51

2.05

Support services

0.78

1.19

Telecommunications equipment

1.38

1.09

Note: Relative technological advantage is calculated as the region’s share in total sectoral R&D relative to the region’s share in overall R&D. A value in relative technological advantage that is higher than 1 means that the region is technology-specialized in this sector. Japan and the rest of the world are not reported because of too few observations when disaggregating to individual sectors. Innovation-based growth sectors are bold and in italics. Source: Bruegel and World Bank staff calculations, based on European Commission’s IPTS R&D Scoreboard.

Because the difference in R&D intensity between Europe and the United States is small for Ollies, the explanation falls to the Yollies. Not only does Europe have fewer Yollies, but those that Europe has are less R&D-intensive.16

Europe’s Yollies are in less innovative sectors so they invest less in R&D Why do Europe’s Yollies have lower R&D intensity than those in the United States? Europe specializes in less innovative sectors. Comparing Yollies within the same sectors shows that Europe’s Yollies are just as R&D-intensive as their U.S. competitors, as expected given the global markets for many of their inputs and outputs.

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Figure 5.9: Innovation-based growth sectors (percentage of total sales, 2007, and annual percent growth, 2004-07)

Note: R&D intensity is expressed as percentage of total sales. R&D growth is average annual growth over 2004–07. The percentages of Yollies among all firms in a sector are in parentheses. Source: Bruegel and World Bank staff calculations, based on European Commission’s IPTS R&D Scoreboard.

Figure 5.10: Only the United States focuses its R&D efforts in innovation-based growth sectors (average relative technological advantage in innovation-based growth sectors, ratio, 2007)

Source: Bruegel and World Bank staff calculations, based on European Commission’s IPTS R&D Scoreboard.

Disaggregating the R&D Scoreboard by sector—listing all that have above-average R&D intensity, above-average R&D growth, or an above-average share of young companies among its leading innovators—can show whether or not Europe specializes in innovation-intensive sectors (figure 5.9).17 The innovation-based growth sector includes aerospace, biotech, computer hardware and services, health care equipment and services, Internet, pharmaceuticals, semiconductors, software, and telecom equipment—all in the ICT and the health nexus (innovationbased growth sectors). With the innovation-based growth (IBG) sectors identified, where are Europe’s R&D efforts concentrated? Europe spends a larger share of its R&D investments in sectors characterized as medium-R&D-intensive, as found by Moncada-PaternòCastello and others (2010; table 5.2). These include automobiles, chemicals, electrics, industrial machinery, and telecom services. None of these sectors is young or has a high R&D intensity; all are older with medium R&D intensity. Further, automobiles, chemicals, and electrics have below-average R&D growth. When looking at individual IBG sectors, it can be seen that Europe has a technological advantage (as indicated by an RTA>1) in aerospace, pharmaceuticals, and telecom equipment. Of these three, only telecom equipment is a “young” sector. The United States, by contrast, specializes in all IBG sectors (figure 5.10). The final step in this decomposition analysis is comparing the relative importance and R&D intensity of Yollies in the IBG sectors across regions. Europe has significantly less of its Yollies in sectors with the highest opportunities for innovation-based growth (figure 5.11, top panel). But the ones it has in these

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Figure 5.11: Europe has fewer Yollies in innovation-based growth sectors, but they are as R&Dintensive as in the United States (R&D intensity in innovation-based growth sectors, percent, 2007)

Note: The shares of Yollies in innovation-based growth sectors are in parentheses.

(relative weight of innovation-based growth sectors in the overall population of Yollies, 2007)

a. Cells with fewer than five observations. Note: In the top panel, the shares of Yollies in innovation-based growth sectors are in parentheses. In the bottom panel, disaggregating the data into sectors, geographic areas, and age groups leaves few observations for analysis, calling for caution when interpreting results. Shaded cells are the young sectors. RDI refers to R&D intensity, which is, as defined above, R&D as percentage of total sales. Source: Bruegel and World Bank staff calculations, based on European Commission’s IPTS R&D Scoreboard.

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sectors are as R&D intensive as their United States counterparts, if not more. In other words, European Yollies are less R&D-intensive than their United States counterparts because they operate in less R&D-intensive sectors. Across most IBG sectors, Europe’s Yollies are just as R&D-intensive as their U.S. counterparts, with a notable advantage in aerospace (figure 5.11, bottom panel). But Europe has a much smaller share of Yollies in the most conspicuous representatives of the knowledge-based economy, such as the Internet (where not one European company makes the list of leading innovators), telecom equipment, biotechnology, and health care.18 Europe’s comparable innovation deficit is due to a structural composition effect, not an intrinsically lower propensity to innovate among its firms (Veugelers and Cincera 2010b). Japan demonstrates an alternative strategy to achieve productivity growth in traditional industries and to maintain global leadership. Germany might be following a similar route. But for Europe as a whole, greater success in innovation-intensive sectors such as ICT, biotech, and health care will be needed to catch up with the technological frontier represented by the United States.

European innovation systems need updating What makes the United States better at generating new technological, organizational, or scientific ideas and applying them successfully in business? Many factors influence the innovation process. We call the interaction of these factors a country’s National Innovation System. The fundamentals include the actors—managers and firms—and the main inputs: capital, skills, and ideas. A review of these fundamentals shows that Europe has several economies that do as well as the United States at creating the basis for innovation—if not better.

National innovation systems Firms decide whether to innovate using existing technologies. In deciding, a firm will typically start by examining its competitive position. Firms facing limited competitive pressure are less likely to innovate, since innovation needs both effort and money (Aghion and Howitt 1998 and 2006).19 The firm will want to know whether it faces a reasonably stable or highly uncertain outlook in its major markets, since innovation is a long-term business. The firm will consider its access to markets with the necessary income level and density of potential customers and suppliers to allow economies of scale inherent in many innovative technologies to be used to their potential. The firm may also respond to opportunities presented by public sector contracts. And last but not least, company managers decide whether to innovate. Quality of management differs, influencing these decisions and whether innovations succeed (Bloom and Van Reenen 2010). A potential innovator will also examine the availability of new ideas that may present a business opportunity, though it is often a scientific discovery or intuition that generates a business idea. An innovator has to assess whether it has the necessary skilled workers to realize this opportunity. The innovator may also be spurred by upward shifts in an industry’s quality standards or by the

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Box 5.5: Where does entrepreneurship flourish? A hundred years ago, the Austrian economist Joseph Schumpeter published his first major work, The Theory of Economic Development, laying the foundation for a large literature examining the role of the entrepreneur in economic development. For most economists, entrepreneurship is an activity responsive to material incentives such as competition, income taxes, or bankruptcy laws, and their influence on risk (Aghion and Howitt 2006). Some economists offer cultural theories of entrepreneurship, which emphasize how value systems encourage people to invest their talents in economic activities (rather than achieving cultural excellence, for instance; for a useful summary, see Shiller 2005). To explain why some regions develop economic clusters and others do not, Glaeser, Kerr, and Ponzetto (2010) examine the supply

of entrepreneurship versus the relative role of economic incentives stimulating demand for entrepreneurial activity, using an established empirical correlation between average company size and employment growth across locations in the United States. Their findings indicate that the supply of entrepreneurship matters. Some regions have a higher density of enterprises to start, reducing costs for others, and allowing clusters to grow (see also Delgado, Porter, and Stern 2010). But some regions are simply lucky to have more entrepreneurial people who, at the right juncture, were able to exploit new economic opportunities. This insight seems confirmed by evidence that attitudes toward values associated with entrepreneurship—such as risk-taking, thrift, and preference for work over leisure—vary across not only countries but also

regions within a country (Shiller 2005). It is likely that a combination of cultural, structural, and economic factors foments entrepreneurial clusters such as Silicon Valley or route 128. In the United States, such clusters have grown to international significance because labor is more mobile, venture capital more developed, and the home market large enough to nurture domestic companies to a global scale. Whether Europeans as a whole are less entrepreneurial than Americans is not clear. The challenge for Europe is to create a network of smaller innovation clusters that achieves the global reach of Silicon Valley. If Europe integrates its services markets, the livability of its historic cities and the quality of its transport network may enable it to compete with California (Crescenzi, RodríguezPose, and Storper 2007).

example of other innovators operating in similar markets. These are factors that influence the supply of ideas that innovators can use. Intermediating between supply and demand are a host of other factors, some specific to innovation, some affecting any investment. Key among these are: the availability of credit, venture capital and “angel” investors (for innovators specifically), and direct public support; intellectual property rights (IPR); regulatory barriers that may discourage innovation (for example, the costs of licensing new technologies, starting up or closing a business, and changed complementary inputs such as hiring and firing labor); and other factors such as the structure and efficiency of the tax or legal system, which influence the probability that an innovator will retain profits. Another factor influencing both supply and demand—and recently receiving considerable attention—is the existence of an “entrepreneurial culture.” There is strong evidence suggesting that attitudes to entrepreneurship vary across countries and regions (box 5.5). Moreover, the presence of other entrepreneurs may stimulate innovators to start a new venture. This explains the interest of policymakers in creating innovation clusters (Lerner 2009; Delgado, Porter, and Stern 2010). Below are three additional observations on the National Innovation System framework (figure 5.12): · Discussions of National Innovation Systems often overemphasize supply-side factors and inputs into the innovation process, neglecting the fact that the best test for any innovation is its success with customers. Understanding and reinforcing incentives for firms to innovate and for entrepreneurs to enter new markets is key to a successful innovation system. Without “market pull,” resources can be wasted. The painful transformation of public R&D institutes

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Figure 5.12: The supply of innovation gets a lot of attention, supply-demand interactions too little

Source: Based on a framework developed by William Maloney, World Bank Development Economics Research Group.

in Eastern Europe and the Russian Federation—well known for their scientific achievements under Soviet rule—is a case in point (Goldberg and others 2011). · Due to the potentially large spillovers of R&D, there is often ample public support. Moreover, coordination failures in “discovering” a country’s competitive advantage have motivated calls for government intervention to promote particular sectors or industries assumed to have high positive spillovers (Rodrik 2004). Although well motivated by empirical examples, these calls should not divert attention from the more mundane barriers to investment, as detailed in chapter 4. “Setting the table” well is necessary for a successful National Innovation System (Lerner 2009). · The interaction between supply and demand matters most. A comprehensive diagnosis is needed to understand what requires fixing. For Europe as a whole, there are important gaps in supply and demand, as well as in the links between them. But in each area where Europe is weak, several countries already achieve global best practice. To understand what might constrain leading innovators in these European top performers, we must turn to Europe-wide factors.

The fundamentals: management quality, adventurous capital, and skills How do European countries compare with their peers—most importantly the United States—in key dimensions of their National Innovation Systems? Using the framework of figure 5.12, a survey of evidence highlights where Europe lags. The survey is selective rather than comprehensive, and is based on findings in the literature rather than original research. Aggregating the data across more dimensions to rank European countries against their peers confirms the findings of Europe’s main innovation weaknesses.

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Management quality in the United States is higher than in Europe In natural selection, the fittest organisms survive, adapting to their environment in unexpected ways.20 What is true in nature is also true for market economies, though many factors intervene in the selection process. Aghion and Howitt (1992 and 1998) stress competition’s importance in stimulating the innovation in companies near or on the technological frontier. But how competition stimulates innovation has only recently begun to be investigated in depth. Bloom and Van Reenen (2010) report the results of research that scores the quality of company management in several thousand companies in 17 countries (figure 5.13). Managers in the United States scored the highest, while many European countries scored quite poorly (see Iwulska 2011 for a summary of the literature). Indeed, Greek companies seem to be as poorly managed as those in Brazil, China, or India. Germany and Sweden do almost as well as the United States—and better than Canada and Japan. The index can be broken down into subindices measuring the extent that managers monitor what is going on, manage human resources with appropriate incentives, and set the right targets and take action when outcomes deviate. The main reason for the United States’ lead is its higher score in managing human resources. Bloom and Van Reenen (2010) attribute the country’s greater use of incentives as management tools to its lighter labor market regulations, which allow poor performers to be more easily removed and top talent more easily attracted and retained. As chapter 6 shows, there are big differences among European countries in the quality of labor market regulations, but as a whole Europe struggles to attract and retain global talent. Another important insight from the research on management quality is that weaker average management scores tend to be associated with tolerance of poorly managed companies, which allows these companies to stay in the

Figure 5.13: The United States outperforms Europe on management quality

Note: Numbers of firms are in parentheses. Data refer to 2006–08. Source: Bloom and Van Reenen 2010. For data, see Nicholas Bloom’s website at Stanford University, www.stanford.edu/~nbloom.

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market (Van Reenen 2011). This insight can be linked to evidence showing that in industries with higher exit rates, productivity growth is faster (Aghion and Howitt 2006). Competition spurs managers to innovate to escape their competitors, pushing poorly performing firms out of the market and raising a country’s aggregate performance. As chapter 4 shows, the survival of poorly performing microenterprises and SMEs is one reason for the poor productivity of Southern European countries such as Italy. Multinational firms and exporters are better managed than domestic firms and nonexporters—in line with results in chapter 4 on the role of foreign direct investment, internationalization, and export orientation for firm performance. A final insight from this research is that better management may increase returns to new general purpose technologies such as ICT. Bloom, Sadun, and Van Reenen (2007) argue that greater use of managerial incentives in U.S. companies has led to better use of the reduction in information costs to decentralize key decisions within the firm hierarchy. This explains why the United States got a larger kick than Europe out of roughly the same levels of information technology investments during the second half of the 1990s, particularly in wholesale, retail, and financial services (van Ark, O’Mahony, and Timmer 2008). Venture capital markets in Europe are thinner than in the United States One of the most frequently cited explanations for the differences in dynamic structure between Europe and the United States is a greater willingness on the part of U.S. financial markets to fund the growth of new firms in new sectors (O’Sullivan 2007). Survey evidence from the German Community Innovation Survey confirms the importance of financial constraints for innovating firms in general, and particularly for young innovating firms (Schneider and Veugelers 2010). The importance of access to external finance—particularly for young, fast-growing innovators—should not come as a surprise. Risk and informational asymmetries create capital market imperfections, and a firm’s lack of reputation and collateral

Figure 5.14: The United States has the largest venture capital market in the world (venture capital investment, percentage of GDP, 2010)

Source: EVCA (European Private Equity and Venture Capital Association) 2011; and Thomson Reuters via PricewaterhouseCoopers/National Venture Capital Association MoneyTree Report, based on Kelly 2011.

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Table 5.3: Average deal size of venture capital investment (euro, millions, 2003–06) Investment stage (EVCA)

Europe

Investment stage (NVCA)

United States

Seed

0.425

Seed/start-up

2.181

Start-up

1.425

Early stage

3.499

Expansion

2.652

Expansion

6.011

Replacement capital

7.208

Later stage

7.699

Note: Investment stages in Europe and the United States are defined by EVCA (European Private Equity and Venture Capital Association) and NVCA (National Venture Capital Association), respectively. Source: Raade and Dantas Machado 2008.

become crucial to how these asymmetries disadvantage it. Although young, highly innovative companies are rich in intangible assets such as technology and specialized knowledge, they lack the collateral assets that could help them access external finance. Young innovators, combining the disadvantages of small scale, short history, risky innovative projects, and less or no retained earnings, can be expected to be more affected by financial barriers. The venture capital market is most adept to address the need of external financing for highly innovative growth projects coming from young companies lacking internal funds. The high risk profile of young, highly innovative growth companies often impedes other modes of external financing, like bank loans. The United States has by far the largest and most developed venture capital market, about twice the size of that of Europe’s leading innovators, Switzerland and Sweden, as a share of GDP (figure 5.14).21 It is not clear, however, whether this disparity reflects the supply side (insufficient funding for potentially profitable projects) or the demand side (insufficient profitable investment opportunities). The evidence provides arguments for both. Kelly (2011) shows that European venture capital, while smaller, chases more deals—leading to fragmentation and smaller investment volumes per deal than in the United States. There is a substantial difference in average investment sizes between the United States and Europe, particularly at the initial stage of seed capital, where the average European investment is just €0.4 million against €2.2 million in the United States (table 5.3). There is also qualitative evidence suggesting that fewer venture capital investors in Europe have an entrepreneurial or engineering background themselves, potentially weakening links with investee companies (Kelly 2011). Venture capital investment in Europe is more diversified and less focused on ICT and biotechnology than in the United States, where IBG sectors account for 75 percent of all venture capital investments. Finally, the lower development of European equity markets means investments may be more costly (box 5.6). These factors put European innovators and especially European Yollies at a disadvantage to their U.S. counterparts in raising financing.

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Yet Skype’s story suggests that venture capital is internationally mobile. In principle, a European yollie should have no difficulty raising financing in the deeper U.S. capital markets. For many years, returns on venture capital investments in the European Union were considerably worse than in the United States, though this gap may now be declining (Kelly 2011; Brandis and Whitmire 2011). Low returns explain low investment flows, and low returns might themselves reflect nonfinancing-related barriers to innovation. Indeed, a likely explanation for limited venture capital financing is that markets for venture capital are too thin. A limited number of investors and entrepreneurs have difficulties contracting with each other at reasonable costs. In European innovation leaders such as Sweden or Finland, though the size of the venture capital market relative to GDP is smaller, availability of financing may no longer be a binding constraint. Europe’s university research lags the United States’ in quality and business linkages An available labor force with the skills to use new technologies is a key factor in encouraging innovation—whether by pushing out the technological frontier or by adopting global best practice in the domestic market. Universities play a key role in educating future cohorts of workers, but they also generate scientific

Box 5.6: Role of financial systems in convergence and innovation Relationship-based financial (RBF) systems played a key role in countries where income convergence was the main challenge, as well as in the reconstruction of Europe after World War II. The main motive was technology absorption. By contrast, arms-length financial (ALF) systems better enable innovation and have gradually risen in importance in continental Europe’s more advanced economies. ALF systems have also played a central role in making the United States and the United Kingdom leaders in innovation. The differences An ideal RBF system emphasizes long-term relationships between customers and financial institutions, with transactions conducted and priced in the context of these relationships. Reputation is integral to this system. The underlying legal framework is less important, and informal enforcement plays a more prominent role, so the institutional and information requirements are fewer. Ownership structures tend to be more concentrated. An ideal ALF system treats financial transactions as stand-alone decisions, each structured and priced according to its merits and provided by the financial institution that can offer the best service. The institutional framework is more demanding, due not only to the necessary legal and regulatory

frameworks but also to the enforcement mechanisms that such frameworks require. In reality, the two systems often commingle. RBF systems are characterized by an aboveaverage importance of banks, small bond and equity markets, and limited emphasis on formal disclosure and corporate governance standards. This is an efficient arrangement to collect savings, monitor borrowers, and select investment projects. ALF systems have smaller specialized banks, a greater importance of capital markets, and extensive formal disclosure and corporate governance standards. The advantages and disadvantages Long-term relationships in RBF systems, often enhanced by equity stakes and board positions, help generate information, providing banks with the opportunity and incentive to obtain in-depth knowledge of their customers, reducing information asymmetry, and facilitating monitoring. The option value for both financial firms and customers of maintaining the long-term relationship provides an incentive to resolve contract disputes that might arise while funding borrowers during lean periods, therefore facilitating longer-term planning and reducing the need for self-insurance. But RBF systems also have disadvantages. The

desire to maintain the value of the investment in existing relationships creates a preference for funding projects in established firms. Borrowers with intangible assets and start-ups with disruptive technologies or strategies challenging incumbents are less likely to be supported. Some analysts even argue that RBF systems stifle innovation by limiting competition (Rajan and Zingales 2002). ALF systems have different advantages. The existence of a broad range of alternative funding sources, coupled with a lower inherent preference for continuing existing financial relationships, raises the likelihood of funding new technologies and firms. It also provides incentives for adjusting rapidly to new economic conditions—and thus to permanent shocks. The reduced importance of lock-in effects for both financial firms and customers generates an incentive for stringent disclosure requirements. But there are disadvantages, too. ALF systems have less repeat business and thus an increased need for self-insurance. Because of the requirement for frequent disclosure, the management compensation structures are tilted toward short-term results. Finally, the transient nature of financial transactions reduces the incentive to resolve disputes internally. An efficient legal system is crucial for an ALF system to function effectively.

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RBF still dominates in Europe, but ALF are on the rise Examining private sector credit and stock market capitalization, after controlling for the characteristics of individual countries— population, demographics, and other features such as being a transition country or an offshore financial center—indicates that banking sectors in Continental Europe are overdeveloped and that equity markets are underdeveloped (box figures 1 and 2). But this is not true for all countries. For instance, banking systems in the Baltic States, Bulgaria, Croatia, Hungary, and Slovenia perform above the world’s benchmark for private sector credit but have underdeveloped equity

markets (except for Bulgaria and Croatia). The southern periphery of the European Union followed a similar path before the financial crisis. For instance, Spain has overdeveloped banking and equity markets, but Italy lags the “old” EU cohesion countries in stock market development. From the standpoint of innovation finance, only a few countries in emerging Europe appear to have excessively expanded their credit markets. And sustained growth differentials relative to the EU15 have narrowed the productivity gap and increased the share of firms with characteristics more amenable to external financing through capital

markets. Moreover, the supporting legal system is more open to ALF systems due to the nature of EU regulatory requirements. Whether a country develops financially is more important than the relative weight of ALF and RBF systems. The experience of emerging Europe is interesting since foreign banks have become a part of RBF systems. But improvements in supporting institutions suggest greater scope for ALF systems in the future. Source: This box draws on Wolf (2011), on the features of RBF and ALF systems, and on Sugawara and Zalduendo (2011), on the benchmarking of banking and capital markets.

Box figure 1: Private sector credit

Box figure 2: Stock market capitalization

(percentage of GDP, 1997–2008)

(percentage of GDP, 1997–2008)

Note: Arrows begin in 1997 and end in 2008, except for Ukraine, which begins in 1998. The arrows in the top-left panel are median values for each country group. The y-axis reflects the indicator referenced in the title of each chart after all effects of structural factors are filtered out and plotted against per capita income with cubic splines (dash lines). Specifically, each of the two indicators is regressed on the mentioned income and structural factors using median estimates of quartile regressions. Source: World Bank staff calculations, based on Beck, Demirgüç-Kunt, and Levine 2000 and 2010.

knowledge that becomes available for business applications. Close links between research institutes, universities, entrepreneurs, and venture capital investors are key ingredients of a successful National Innovation System. And universities are an important vehicle for countries that wish to attract global talent—both academics and students. The United States outperforms Europe on all three counts. European governments regard scientific research as a primary responsibility of the public sector, placing less emphasis on leveraging private funding for scientific discovery. While total funding per student correlates closely with GDP per capita, in the United States the average ratio of spending per student to GDP per capita was 58 percent, against 55 percent in Canada and between 40 and 50 percent in most advanced European countries (Italy lags with less than 30 percent). Differences in private funding explain the bulk of spending

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Figure 5.15: Most European countries produce fewer graduates than the United States or Japan (percentage of the population ages 30–34 that has completed tertiary education, 2010)

Source: International Institute for Applied Systems Analysis and Vienna Institute of Demography (IIASA/VID), via World Bank Education Statistics (EdStats).

Figure 5.16: Europe is falling behind the United States in top university rankings (world’s top 100 universities)

Source: World Bank staff calculations, based on data from Shanghai Jiao Tong University and Thomson Reuters/Times.

differences per student. Similarly, while public funding for researchers in the United States and Europe is roughly the same, Europe’s per capita funding per scientist is only around 40 percent of the United States’ level because the United States has far fewer publicly funded researchers. The European Research Council, with a budget of around €1 billion a year, attempts to provide more targeted and scaledup research grants to European centers of excellence to overcome fragmentation. Greater public funding has not led to a larger share of the workforce with higher education. Japan has the highest share of graduates in its population, with a mixed funding system (figure 5.15). The United States has a better average than the European Union, though several European countries with predominantly public funding outperform the United States.22 Public funding often comes with less flexible governance, allowing for less diversification in courses offered and weaker ability to attract, remunerate, and retain top faculty (Aghion and others 2005).

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Figure 5.17: Science-business links are as strong in Europe’s top performers as in the United States (public-private co-publications, per millions of population)

Note: Data refer to different years by country. Source: European Commission 2011b.

The consequences of this policy choice: First, Europe’s universities underperform their United States peers in indicators measuring the quality of scientific output and the education opportunities offered. Second, the links between scientific research and business are more developed in the United States, and the U.S. system is more likely to generate scientific discoveries that turn into commercial “hits.” Third, the United States outperforms Europe in attracting and retaining global talent to boost the quality of its workforce. According to the rankings of the world’s top 100 universities produced by the Shanghai Jiao Tong University and the Times Higher Education Supplement index, European universities lag behind the United States—particularly at the top (figure 5.16).23 Moreover, both rankings show Europe losing to the United States over 2004–10. While in absolute numbers the United States dominates in quality universities, some European countries do well relative to their population. The United Kingdom, with two top 20 universities (Oxford and Cambridge), is an obvious example, but Belgium, Denmark, the Netherlands, Sweden, and Switzerland all have a higher share of top 200 universities per 1 million population than does the United States. Once again, within Europe there are innovation leaders that match the quality of the U.S. National Innovation System, even if Europe as a whole is falling behind. Emerging technologies are often built on insights from frontier research, developed at universities or research institutes. The links between science and business are thus as critical as the quality of the science. Such links are forged more easily when researchers and entrepreneurs are close to one another, leading to attempts to create global innovation clusters around centers of academic excellence. The obvious examples are Silicon Valley in California for ICT, the greater Boston area and the area around Cambridge in the United Kingdom for biotech, and the Munich and Zurich areas for engineering. The United States is fortunate to have top research universities producing frontier research. The U.S. National Innovation System is unique in how its top research universities interact productively with businesses. Interactions between science and industry can take various forms—including formal relationships, such as collaborative agreements between science and

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industry; R&D contracting, but also own licensing policies and intellectual property management; and spin-off activities of science institutions. Behind this group of formal links are myriad informal contacts, personnel mobility, and sciencebusiness networks on a personal or organizational basis. These informal contacts and human capital flows exchange knowledge between enterprises and public research, creating spillovers. While more difficult to quantify, informal contacts are nonetheless important, often instigating more formal contacts. There are few available quantitative indicators that demonstrate the strength of links between industry and science across countries.24 The IUS reports public-private co-publications as a measure for science-business links (figure 5.17). It shows that the top countries in Europe in co-publications are Switzerland and the Scandinavian countries, which are also the innovation leaders overall, indicating that strong links between universities and the private sector are necessary for a well-functioning innovation system. University patents illustrate the capacity of a nation’s science system to contribute to technological development (table 5.4).25 When measured by quantity and use by the corporate sector, different profiles for Europe, Japan, and the United States emerge. Table 5.4: United States universities produce more patents, and if picked up by business, the patents have greater impact (citation-based statistics for all countries with at least 100 university patents) Note: The analysis uses application data from the European Patent Office for 1980–2000, which allows a citation window of 10 years (until 2010). Citations are from all patent systems (United States Patent and Trademark Office; European Patent Office). The patent impacts are measured by the amount of citations received per cited patent.

University patents

Country share in university patents (percent)

Country share in corporate citations of university patents (percent)

Percentage of university-owned patents that are cited by company patents

Impact of cited university-owned patents

United States

13,088

69.8

66.8

14

6.03

United Kingdom

Country

1,813

9.7

6.5

15

3.96

Canada

868

4.6

3.1

14

4.34

Australia

605

3.2

1.2

9

3.90

Belgium

553

2.9

6.2

36

5.17

France

455

2.4

2.3

28

3.03

Netherlands

427

2.2

3.0

28

4.26

Germany

278

1.5

1.4

22

3.89

Japan

272

1.4

3.8

49

4.77

Switzerland

180

1.0

1.1

23

4.29

Spain

124

0.7

0.9

40

2.98

Italy EU15 average

101

0.5

0.5

21

3.90

4,062

21.7

22.8

28

3.74

Source: Veugelers and others 2011.

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In quantity, the United States dominates, producing a large volume of university patents and leaving the EU15 behind. But just 14 percent of U.S. academic patents are cited by the corporate sector, compared with 28 percent for the EU15 and 48 percent for Japan. These countries have fewer but more frequently

Figure 5.18: The United States has the largest market share for international students (percentage of all foreign tertiary students, 2008)

Source: OECD 2010.

Figure 5.19: Switzerland, Scandinavia, and Germany are global innovation leaders

(EU27 and non-European states, percent, 2010)

Source: European Commission 2011b.

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(index for individual European countries, 2010)


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cited university patents. When looking at the average number of citations received, conditional on being cited, the United States again leads the EU15 and Japan, as their university patents have a higher average impact. The U.S. model of technical innovation is one of experimentation on a massive scale. U.S. universities generate a large volume of patents, but few are “used” in creating corporate technology. At the same time, this large volume provides fertile ground for university patents to turn into commercial “hits.” The biotech (pharmaceutical) field employs this experimentation process. The profile of Europe suggests more mediocrity: universities are much less active in generating patents, only bringing out ideas more likely to be used commercially. However, with less experimentation, European universities are less likely to register “high-impact” patents. In Europe, there is considerable heterogeneity, which can be traced back to IPR legislation and institutional set-up (Veugelers and others 2011).26 Japan’s university patents are the most likely to be cited by company patents, but— conditional on being cited—their average impact is not exceptionally high. Moreover, the total share of corporate citations traced back to U.S. university patents is almost as high as the share of U.S. universities in the quantity of all patents produced. The higher probability of patent citations by U.S. companies suggests that U.S. universities provide more truly global knowledge, despite the predominance of local science-business links in all countries. The citation flow also shows that U.S. corporations are more likely to source knowledge globally, citing patents registered by non-U.S. universities. Not only does the United States have the strongest local science-business links of any country, it leads in globalizing these links, building on experience gained at home. Europe’s lower success in attracting global scientific talent and students is the third consequence of its underperforming science and university complex. The United States dominates the market for international students (figure 5.18). In advanced U.S. research programs, close to a third of all students are international. Many of Europe’s most promising researchers are attracted to the United States by better remuneration packages (Salmi 2009), better teaching and research facilities, and the greater density of talented colleagues and students.

Europe’s innovation systems ranked and compared The evidence surveyed so far points to four distinct country groups in Europe. First, there are the leading innovating countries, including the Nordics, Switzerland, and Germany. On many dimensions, this group either equals or outdoes the United States and Japan. Second, there are the continental economies, the United Kingdom, and Ireland, which are performing reasonably well, though not at the level of global leaders on most dimensions. Third, there are the Southern European economies, which have struggled to increase productivity, reflected in relatively weak innovation systems. And fourth, there are the emerging economies in Eastern Europe, including front-runners in the EU12, who have on most dimensions exceeded the south and economies where innovation does not appear to be a policy priority given general constraints to the business environment (Goldberg and others 2011). We now summarize this evidence by using the European Commission’s IUS indicator—a composite indicator using some data in this report and a few additional

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measures.27 On the aggregate IUS indicator, Europe as a whole performs poorly (figure 5.19, left panel). The United States has the highest IUS score, followed closely by Japan. The United States score in 2010 was 49 percent higher than that of the EU27. This gap persisted over 2006–10 (in 2006, the United States score was 46 percent higher). Relative to the main emerging market economies, Europe still has a considerable lead. But except for the Russian Federation, the BRIC countries—especially China—are catching up fast. This aggregate result confirms that Europe’s National Innovation Systems need updating. Europe’s best are performing as well as the United States, while its least innovation-friendly economies are not different from emerging economies elsewhere, and may even lag the BRICs. The IUS for 33 European countries, covered by all 25 subindicators (essentially most of the EU27, the European Free Trade Association, and candidate countries), shows that Switzerland had an IUS score about 60 percent higher than the EU average (figure 5.19, right panel). Although the data are not strictly comparable since not all subindicators are available for non-European countries, Switzerland is arguably on par with the United States on most dimensions of its National Innovation System. Finland, Germany, Denmark, and Sweden also do well. The weakest group includes mostly transition or EU candidate countries. The bottom seven are Latvia, Turkey, Bulgaria, Lithuania, the former Yugoslav Republic of Macedonia, Serbia, and Romania. But the innovation divide in Europe does not follow a simple transition divide. Among the innovation laggards are some older member states, notably Spain and Italy, while Estonia and Slovenia have already joined Europe’s more innovative half.28 The rankings in figure 5.19 are thus consistent with the pattern observed by looking at the individual dimensions of the IUS score, as well as other rankings of innovation capacity within Europe, such as the World Competitiveness Indices. The rankings are also persistent over time—the top five countries in 2006 were the same as in 2010, though Sweden ranked ahead of Switzerland in the top spot. The bottom five did not change either.

Achieving global leadership for Europe’s best The Nordic economies, Switzerland, and Germany are getting the innovation fundamentals right, combining public support for innovation with private incentives to profit from it. Is there something Europe’s other countries can learn from its leaders? Does Europe’s failure to specialize more in IBG sectors, and thus benefit from the spillovers that come from innovation-intensive activities, reflect an industrial policy failure, even among its leading countries? The answer to the first question is yes, but implementing public support for innovation is difficult and institutionally demanding. Failure abounds and caution is in order. The answer to the second question is no. Instead, Europe’s failure to achieve global leadership in IBG sectors has more to do with three factors: its segmented labor and services markets; the nature of incentives for innovation resulting from European antitrust legislation and the absence of an integrated public procurement market; and unnecessary transaction costs imposed by the absence of a single European patent or greater bundling of public funding for scientific research. This does not exclude a role for cultural or other

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idiosyncracies that might have helped create technology clusters in the United States, such as Silicon Valley. But there is much that Europe can do at the policy level to encourage its own clusters to grow to a global scale, without appeal to good luck or good weather.

An industrial policy for the 21st century? Finland is a top innovator in Europe. Its total investment in R&D was 3.9 percent of GDP in 2009 (European Commission 2011b), the highest in Europe and second-highest in the world. Finland has the second-highest registration of patents per euro of GDP in Europe, and the second-largest share of innovating companies cooperating with firms outside Europe. Over 1995–2009, Finland’s annual productivity growth was 1.5 percent and its rate of job creation 1.3 percent, making for one of the fastest GDP growth rates in Europe (chapter 4). Finland’s innovation success is the result of conscious national policy.29 At the heart of this policy is public support for commercially targeted R&D through the National Technology Agency of Finland. This organization provides matching grants and subsidized and convertible loans geared to early-stage technological development. And, administering around a third of the public sector’s R&D spending ($1.9 billion in 2009, or slightly more than 1 percent of GDP), it is complemented by a publicly owned venture capital fund (SITRA). SITRA provides funding for preseed start-ups; a public applied research institute that, while publicly owned, obtains a third of its revenues from sales to the private sector; and basic research through the Academy of Sciences and universities. Political leadership is an important factor: the prime minister chairs a national research and innovation council. Yet, policy instruments have generally gone with the market by leveraging market incentives, rather than substituting for business decisions. Finland is not alone in boosting innovation through active public support. Financial incentives, matching grants, targeted procurement policies, and other measures have helped boost innovation and venture capital from Silicon Valley to Singapore, and Tel Aviv to Bangalore. But many more times public interventions have failed. Lerner (2009) summarizes the evidence as a “boulevard of broken dreams.” Typical mistakes include public support programs that are of insufficient length and flexibility; that do not leverage an existing scientific and research base, disregarding agglomeration economies; that fail to let the market provide direction, setting national standards rather than following global best practices; that are either too large or too small and fail to pay sufficient attention to careful monitoring so that adjustments can be made; and that are not evaluated, so that policymakers and stakeholders do not learn from mistakes. Successful public policies to support innovation often require governance structures unlike those usually found in the public sector. This conclusion echoes a more general point about industrial policy: where public interventions can catalyze or emulate competitive market selection, and where they can encourage experimentation despite imperfect information, they can lift an economy’s overall performance (Aghion and others 2011). Too often industrial policy tries instead to prevent competition, and another broken dream takes its place along the boulevard.

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On the agenda: single market, competition, and public procurement The demand for innovation investments is a function of market pressures and perceived opportunities. Because the commercial opportunities resulting from innovation are greater when markets are larger and denser, the degree of market integration (or “thickness”) matters. In this respect, Europe is disadvantaged for two reasons. First, companies in Europe operate within domestic borders, due largely to the incomplete realization of the single market—particularly in services—and to other EU policies. The incomplete realization reduces the incentive to innovate, as the market of potential consumers remains smaller and competition lower. Second, Europe’s labor is not as mobile as that in the United States (chapter 6). Mobile labor allows the U.S. economy to respond more rapidly to shifts in the technological frontier, realizing agglomeration benefits in newly emerging centers of excellence. By rapidly reallocating resources in line with new technologies, the U.S. economy has a higher capacity for shifting to new technologies and markets. Pelkmans and Renda (2011) highlight a striking example of the lack of market integration in communication services, one of the IBG sectors identified earlier.30 Despite three packages of market liberalization, the European Union has failed to develop an integrated market for e-communications. In the European Union, the highest price for a wide range of e-communication services exceeds the lowest price by several multitudes (up to 1,300 percent in the case of fixed-line calls to Japan!). The average monthly spending of European businesses differs by as much as 270 percent (not counting outliers), whereas the difference between New York and California is close to zero. The same is true in residential telecom bills. Of perhaps greater economic significance, given the impact on the cost of information flows and thus the scope for productivityenhancing decentralization (Bloom, Sadun, and Van Reenen 2007), the quality of broadband services differs greatly within the European Union—and not only because of differences in incomes and available infrastructure. Regulatory obstacles—traceable to the existence of national telecom regulators in each EU state and to the lack of a Europe-wide approach to promoting investment in network industries—are partly to blame. Research suggests that a single digital market in the European Union would noticeably boost Europe’s economy. Tilford (2008) notes that Europe has been gradually losing its R&D leadership in pharmaceuticals to the United States. Between 1990 and 2005, the annual growth rate of pharmaceutical R&D in the United States was 4.6 percent, compared with just 2.8 percent in the European Union. One reason may be that national price regulation leads to market segmentation and free-riding by EU member states that are not hosts to large pharmaceutical companies. Prices in Southern Europe tend to be significantly lower than in Germany, the Netherlands, Scandinavia, and the United Kingdom, where most R&D in pharmaceuticals happens. Europe’s high-price markets, smaller than those in the United States, may limit incentives for companies to develop, test, and introduce new drugs in Europe. And the average price for patented drugs in the European Union was only half that in the United States. This may keep health costs down (chapter 7), but it is bad for innovation. Moreover, the arbitrage opportunities resulting from price differences in the European Union may lead

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pharmaceutical companies to attempt to restrict sales in low-price markets to the detriment of patients. Crescenzi, Rodríguez-Pose, and Storper (2007) estimate a so-called knowledge production function, which compares the number of patents registered to R&D investments in Europe (and a number of other factors at the regional level) with that in the United States. An insight from their analysis is that in the United States, knowledge production is more concentrated at the regional level, and there are fewer spillovers to other regions. In the European Union, R&D produced in one region helps generate patents in regions as far as several hundred kilometers away. This pattern may weaken incentives to create regional centers of excellence large enough to attract global leaders, risking the duplication of R&D across regions in Europe. In a nutshell, Europe’s most successful innovating economies are not big enough to allow innovators to grow to global leadership. A particularly prominent example for European fragmentation in innovation policy is the absence of a single Europe-wide patent. Leading European countries cannot agree on which languages to register the patent in. This is a case where overcoming national pride and prerogatives will be critical to create functioning Europe-wide innovation clusters. It is not just barriers to the single market resulting from national regulations that may reduce incentives for innovation-based growth sectors to develop. EU policy may have a role too, important in competition policy and procurement. Mowery (2011) discusses the role of competition policy and IPR protection in the evolution of R&D in the United States. During the postwar years, antitrust legislation prevented established U.S. companies from acquiring new technologies through mergers and acquisitions, thus promoting the birth of small innovative companies in new technologies such as semiconductors and electronics. After 1980, U.S. policy became considerably more patent-friendly. With the Bayh-Dole Act, the United States tightened protection of IPR, leading to an explosion in patents and collaboration among firms to benefit from technology diffusion. The role of the Bayh-Dole Act in promoting business-relevant research by universities—and the greater role of patent revenues for universities—has led Denmark and Japan to emulate its provisions. There are, however, critics of tight IPR regimes—regimes that could lead to strategic use of patents to prevent new entry, with little value created in the process. Tilford (2008) discusses the European Commission’s interpretation of its competition policy mandate with respect to network industries such as ICT, noting that an overly stringent interpretation of consumer risk from dominant market power may fall short. In industries where benefits to consumers may increase with the number of consumers, market dominance may not harm consumer interests. At the same time, companies anticipating antitrust action may hold back from innovation. The design of competition and IPR policies is an important element of a Europe-wide National Innovation System, though Mowery (2009) emphasizes that successful U.S. policies may not bring the same result in places with a different tradition of university-business collaboration. Finally, the United States’ success in innovation-based growth sectors owes a good amount to an integrated national procurement policy, particularly in the military and defense sector. Access to early users willing to take up and co-develop innovations is critical for new firms entering new sectors. One early customer

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is the government. In many health and ICT sectors, history has shown U.S. public institutions to be an important early user, pivotal in leveraging further private markets through public procurement (Mowery 2009; Lerner 2009). In Europe, the use of public procurement as a policy tool to foster innovation and structural change is much less developed and far from integrated on a European scale (Monti 2010).

America’s innovation machine versus Europe’s “Vorsprung durch Technik” As corporate emblems of their continents, it is not unfair to contrast Apple and Audi. Since its inception in 1976, Apple has revolutionized the computer industry, changed the way music is bought and heard, and made the telephone a smart device, capable at once of voice, visual, and data communications. In 35 years, the company has transformed three industries. It has rewarded its shareholders and grown big while still young. Indeed, in summer 2011, Apple briefly became the world’s largest company by market capitalization. Audi was founded more than a century ago, and its main innovation was to produce the first left-hand drive cars, making driving in traffic easier and safer. A luxury arm of the massive Volkswagen Group since 1965, it has been making cars safer and more reliable ever since. Both Apple and Audi are global companies, sourcing parts from around the world and manufacturing products in countries where assembly is cheapest. But one is an emblem of unimaginable innovation, the other perhaps of persistence. One is a Yollie, having grown big while still young, and the other is an Ollie, becoming big only after it became old. European leaders have long recognized Europe’s innovation deficit relative to the United States, Japan, and other countries in East Asia. The European Union even carved into its 2002 Lisbon Strategy the ambition to become the most competitive knowledge-based economy in the world. In the subsequent EU-2020 strategy and Innovation Union Flagship, it set a roadmap for sustainable and inclusive growth to be “smart” (for example, European Commission 2011a). European efforts focus on investment in R&D. An ambitious target of devoting 3 percent of GDP to R&D by 2010 was set in 2002. The same 3 percent was again targeted in the EU-2020 strategy. But reality has disappointed. R&D as a share of GDP has remained less than 2 percent in the EU15, and the gap between its R&D investments by the business sector and those of the United States—and even East Asia’s high-income countries such as Japan, the Republic of Korea, and Singapore—has been growing. It is increasingly apparent that such R&D targets are unrealistic; it may also be that they are not optimal. Yet, as the analysis has shown, Europe is capable of creating successful National Innovation Systems, which stand toe-to-toe with the world’s leading innovation machine: the United States. This raises the question: What are the characteristics of successful innovation systems in Europe? In particular, are there any uniquely European features of effective systems?

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One clue is that Europe’s leaders perform especially well where Europe lags as a whole. For example, Switzerland has revenues from international licenses and patents of 2.5 percent of GDP, 10 times the EU27 average and more than 3 times that of the United States. Sweden’s licensing and patent revenues were more than 1 percent of GDP in 2008, Finland and Denmark’s around 0.7 percent, about the same as that of the United States (European Commission 2011b). Finland’s population of 30–34-year-olds with tertiary education exceeds the level in the United States and is close to Japan’s; Finland’s business R&D was almost 3 percent—on par with the United States. Public-private co-publications were between three and six times larger in Europe’s innovation leaders than in the EU27 average, and much higher than in the United States. So, how are these aggregate differences reflected at the enterprise level? Europe’s innovation deficit relative to the United States can be attributed in part to the lack of Yollies in innovation-based growth sectors. European companies in traditional sectors do not innovate less than their competitors in the United States. But Europe has far fewer Yollies and is much less specialized in sectors characterized by innovation and rapid productivity growth—such as ICT, biotech, and medical technologies and services. This finding comes with a caveat: to measure innovation at the firm level, the analysis relies on R&D investments. This is obviously not the only way to measure innovative behavior. But the list of major R&D spenders overlaps other rankings of the world’s most innovative companies. In short, while the United States has Apple, Google, Amazon, Microsoft, eBay, and Facebook, Europe has BMW, Mercedes Benz, Siemens, Vodafone, and Nokia.31 And what measures should European countries take to fix their innovation fundamentals? Three policy priorities emerge. First, speed up the integration of markets for business services and skilled labor to increase the thickness of markets for innovators, and shift resources rapidly to new, untested business opportunities. Doing so leads to more competition in IBG sectors, dominated by services. Second, improve incentives in scientific research and university education systems to generate ideas that can be business successes. Third, assess the role of venture capital in catalyzing the growth of Yollies, both in providing access to patient capital and ensuring attention to good management. Venture capital markets are integrated globally, and public policy to attract such financing is difficult to design, so the early focus should be on setting the table before launching into specific programs of public support. These things are difficult to do, so this analysis has daunting implications for Europe’s policy agenda. The evidence suggests that policies aimed at raising R&D expenditure across all types of industries and firms do not address the roots of Europe’s innovation deficit. Policies need to address the barriers to developing new high R&D-intensity sectors and firms, as the evidence has shown how pivotal these sectors and firms are for tackling the deficit in Europe’s capacity to shift. These barriers have roots in poor access to early risk-financing, frontier research, specialized knowledge and skills, and risk-taking lead customers, including the government. Lacking this access, aspiring young innovators are hampered in their search for partners to develop, finance, produce, market, distribute, and sell their breakthrough innovations. A general innovation policy for improving the risk-taking environment is needed. Yollies need to interact with other innovators, and innovators should not be impeded

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while they mature, so a policy to address the lack of young firms in new, R&D-intensive activities needs to fit in an overall innovation framework. This overall innovation policy should further integrate the European capital, labor, and goods and services markets, making it easier for players in the innovation system to interact and thus creating competition. Updating Europe’s overall innovation policy framework should also look closer at competition and IPR policies, where finding the balance between promoting new entry and creating incentives for innovators by protecting their innovation is a delicate task. Agreeing on a single European patent would be a simple but important step forward. Europe’s leading innovators in Scandinavia, Switzerland, and around the Baltic Sea have narrowed the gap with the United States in access to venture capital and in the quality of science and universities. But even they still depend on decisions in Brussels to address the weaknesses in the single market for modern services. Constraints are exacerbated by Europe’s sluggish labor markets, which slow the adoption of new technologies and the shift in effort from old and stagnant to new and growing sectors. How can these constraints be eased? Chapter 6 tries to answer this.

Answers to questions on page 245

Europe’s innovation deficit matters most for the EU15, and so it also matters for the economies of emerging Europe because they are closely integrated. European enterprises do less R&D than American firms because they tend to be in sectors that are not as innovation-oriented. The most innovative European economies such as Switzerland spend a lot on R&D, but also share key attributes with the United States—tight business–university links, good management skills, and top universities. Measures to fully integrate the Single Market for Services will provide the scale, more privately funded universities will supply the skills, and regulations that foster competition will create the incentives for European enterprises to innovate. 282


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Chapter 5: Annexes Annex 5.1: Indicators used in the innovation union scoreboard The Innovation Union Scoreboard (IUS) is a composite indicator composed of indicators capturing eight dimensions of innovation: · Human resources. · Research systems. · Finance. · Firm investment. · Linkages and entrepreneurship. · Intellectual property rights. · Innovators. · Economic effects. Within Europe, the IUS covers 34 European countries over time: 27 EU Members (15 old member states and 12 new member states) and Switzerland, Norway, Turkey, Croatia, Iceland, Former Yugoslav Republic of Macedonia, and Serbia. For the intra-European comparison, 25 indicators are used.32 · Human resources: new doctorate graduates, population ages 30–34 with completed tertiary education, youth ages 20–24 with upper secondary level education. · Research systems: international scientific co-publications, top 10 percent most-cited scientific publications worldwide, non-EU doctorate students. · Finance and support: public R&D expenditures, venture capital. · Firm investments: business R&D expenditures, non-R&D innovation expenditures. · Linkages and entrepreneurship: small and medium enterprises innovating in-house, innovative small and medium enterprises collaborating with others, public-private scientific co-publications. · Intellectual assets: Patent Corporation Treaty patent applications, Patent Corporation Treaty patent applications in societal challenges, community trademarks, community designs. · Innovators: small and medium enterprises introducing product or process innovations, small and medium enterprises introducing marketing or organizational innovations. · Economic effects: employment in knowledge-intensive activities, medium and high-tech manufacturing exports, knowledge-intensive services exports, sales of new-to-market and new-to-firm innovations, license and patent revenues from abroad.

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Outside Europe, the comparison countries included the United States, Japan, and the BRIC countries (Brazil, the Russian Federation, India, and China). Because of limited data availability, only 12 indicators from the 25 were used for comparing countries outside Europe. These indicators are for human resources: new doctorate graduates (ISCED 6) per 1,000 people ages 25–34, percentage of people ages 25–64 with completed tertiary education; for research systems: international scientific co-publications per million people, scientific publications among the top 10 percent most-cited publications worldwide as a percentage of total scientific publications of the country; for finance: public R&D expenditures as a percentage of GDP; for firm investment: business R&D expenditures as a percentage of GDP; for linkages and entrepreneurship: public-private co-publications per million people; for IPR: Patent Corporation Treaty patents applications per billion GDP in euro adjusted by the purchasing power standard (PPS€), Patent Corporation Treaty patent applications in societal challenges per billion GDP (in PPS€) (climate change mitigation, health); for innovations: none; for economic effects: medium- and high-tech product exports as a percentage of total product exports, knowledge-intensive services exports as a percentage of total service exports, license and patent revenues from abroad (as a percentage of GDP).

Annex 5.2: The dataset on leading innovators We start with the firms belonging to the EU-1000 and non–EU-1000 largest R&D spenders in the 2008 edition of the EU Industrial R&D Investment Scoreboard.33 This dataset was augmented with information on the age of the firm’s creation.34 The information on the firm’s age allows the United States to distinguish between young and old leading innovators. As the scoreboard database only records the largest R&D spenders, “young firms” are not small start-ups. Indeed, the average size for the young firms in our sample is 10,000 employees worldwide. Some top young firms in our sample (by R&D size) are Microsoft, Cisco, Amgen, Oracle, Google, and Sun. As it includes (almost) no firms with fewer than 250 employees, the scoreboard dataset is not suited for analyzing small and medium enterprises. The young firms in our analysis managed on their own (without being taken over), in a short time since their birth (after 1975), to grow to a leading global position deploying substantial R&D resources. We will label them young leading innovators (Yollies) and old leading innovators (Ollies). Besides the age of the firm’s foundation, the dataset contains information on the following variables: main industrial sector (according to the Industry Classification Benchmark), country of origin, net sales, number of employees, and R&D investment for each year over 2004–07. The geographic classification of firms is based on ownership, not on location of the activities.35 Due to missing data for some firms, the final sample includes 1,111 firms. Of our sample firms, 32 percent are from Europe, 38 percent from the United States, 19 percent from Japan, and 10 percent from the rest of the world.36

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Notes 1

The Estonian programmers were Jaan Tallin, Ahti Heinla, Priit Kasesalu, and Toivo Annus. The company founders were Niklas Zennstroem (Sweden) and Janus Friis (Denmark).

2

This analysis presents productivity as GDP per hours worked, as is common in the literature (figure 5.1). If we were to use GDP per person employed, as in chapter 4, Europe’s leading economies would reach only around 83 percent of the United States peak in 1990. Moreover, the north would overtake the continental economies in labor productivity around 2003. The basic pattern that interests the United States in this chapter—the reversal of convergence in productivity between Europe and the United States after 1995—would remain.

3

4

5 6

7

Among technology followers, demand for a particular vintage of products is given. Market share declines with the number of competitors, reducing returns on moving into a new product vintage through adaptation. At the frontier, however, innovation creates new demand by offering new product types. A general caveat: the measurement of productivity in services is fraught with problems. For instance, final prices for many services reflect both quality improvements and cost reductions, but quality improvements are often insufficiently captured. It is not clear whether such measurement issues affect cross-country comparisons of productivity growth in services. To the extent that they do, the conclusions drawn in the literature referenced in this chapter would also be affected.

8

9

There are significant differences in the productivity of R&D. The transition economies of Europe and Central Asia, for instance, are characterized by much higher costs of R&D investment per patent registered than the EU15 or the United States (Goldberg and others 2011). By and large, countries that generate a lot of R&D, particularly in the business sector, have a larger output of innovations, as measured by patents and corresponding business applications.

The data do not tell us what this spending is on. They are calculated as a residual from overall innovation spending minus R&D. The denominator is enterprise turnover. The data are obtained from enterprise surveys.

10

Goldberg and others (2011) examine collaboration of business across borders in patent registrations. Generally, data on collaboration show an upward trend, but in the past decade, the region has been falling behind such countries as China and India. For technology followers, collaboration across borders may be particularly important to absorb and adapt cutting edge technologies for domestic applications.

11

These are aggregate data based on a simple growth accounting framework, subtracting investment in physical capital and labor inputs, but do not account separately for ICT investments or structural shifts in the economy, as in van Ark, O’Mahony, and Timmer (2008). Data are also reported for the United States but not for a larger sample of countries. We therefore do not know whether the EU12 are outliers among emerging markets.

See also Dewatripont and others (2010). The Selected Indicators table A5 reports selected data series that draw on the original source data quoted in the IUS. In some cases, data used in the IUS are not available for non-European countries, and alternative data series are reported. We have checked the robustness of the results in the IUS against alternative data series and indicate where results diverge. The main conclusions are not affected.

The patent data in the bottom panel come from the IUS and refer only to patents registered under the Patent Cooperation Treaty. In the Selected Indicators, we also report the data on patent counts based on all patents registered under the Treaty, whether with national patent offices or under the European Patent Office. Countries such as Brazil, China, Japan, and the Russian Federation considerably improve their ranking against smaller European countries using this alternative measure. We prefer the IUS data given the market significance of an international registration with the European Patent Office.

12

13

It would be preferable to link TFP growth to a measure of innovation at the start of the period. The Commonwealth of Independent States data are, however, only collected since 2006, and there is not much change in the cross-country distribution in the other two measures over time. The results should be seen as indicative, not conclusive. Based on an analysis of the top 1,000 global firms in market capitalization, which were listed in Business Week in 1999, Cohen and Lorenzi (2000) found that information technology was by far the most important sector in determining the difference in the total number of new giants between the two regions.

14

Using firm-level information from the scoreboard of largest R&D spenders, it is possible to trace the age and sectoral profile of the largest firms investing in R&D. As the number of observations quickly becomes low, however, particularly when age groups in sectors in regions have to be analyzed, the level of individual European countries cannot be used for analysis. Annexes 2 and 3 describe the scoreboard data and its caveats. Veugelers and Cincera (2010b) performed and reported a similar exercise for the EU27 countries.

15

Finland (four Yollies), Sweden (three), Spain (two), Italy (two), and Iceland, Denmark, Luxemburg, and Austria (each with one) complete the picture.

16

Veugelers and Cincera (2010a) perform a decomposition analysis to calculate the exact size of these effects. This analysis shows that the contribution of Ollies to the total deficit in R&D is small. The most important factors to explain Europe’s overall poor business R&D performance are that Europe has fewer Yollies and that the Yollies it has are less R&D-intensive. Having less R&D-intensive Yollies accounts for more than half the business R&D deficit with the United States.

17

This precludes any analysis at the country level, so only aggregate differences between Europe and the United States are reported.

18

For an interesting comparison of European and U.S. spending patterns on health care and the implications for innovation in the sector, see Cowen (2006).

19

Although the relationship between competition and innovation is not linear, firms well below the technological frontier may actually be discouraged from innovating if competition is too intense.

20

For examples, see the British Broadcasting Corporation’s Planet Earth series.

21

Because of significant year-on-year volatility, the ranking among countries changes quite a bit across years. But the United States is always the largest market for venture capital—both in absolute terms and as a share of GDP.

22

The data used in figure 5.15 come from IIASA/VID. Data in the IUS indicate that the United States has a large advantage over Europe in the share of graduates in its population, but the IUS for the United States only reports graduate shares among people ages 25–64, thus reflecting cumulative investments in tertiary education, not recent investments.

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23

The Shanghai Ranking ranks universities on a set of indicators measuring their research performance. The indicators include the number of alumni winning Nobel Prizes, the number of university faculty winning Nobel Prizes, the number of articles published in Nature and in Science, the number of articles published in ISI Web of Science journals, the number of highly cited researchers, and the size of universities.

24

The World Economic Forum reports qualitative measures of the businessresearch links, based on interviews with executives. Managers are asked to rank the quality of research institutions and the extent to which they collaborate with business. The United States, Switzerland, the United Kingdom, Germany, and Sweden come out on top. The transition economies are mostly at the bottom of the European ranking, but Italy and Greece rank worse than Turkey and Ukraine. The Czech Republic and Hungary score roughly the same as Austria and Luxembourg (Schwab 2011).

25

An ANCOVA confirms that country differences, as well as technology fields of the cited and citing patents, explain a considerable share of the observed variance in the share of cited university patents. In terms of impact, country effects prevail (Veugelers and others 2011).

26

Within the EU15, Belgium’s university patents hold a top position in corporate citations received. Not only do Belgian university patents have a higher probability of receiving citations by corporate patents, they also have the highest impact in Europe. The success of Belgian university patenting is due largely to the country’s Interuniversity Microelectronics Centre.

27

The aggregate score is based on 8 dimensions comprising 25 indicators. Each indicator is normalized, and the aggregate score is the unweighted average. For comparisons with non-European countries, only 12 indicators are available. See annex 1 for details.

286

28

Radosevic (2004) found similar results. In addition to a high-tech “north” cluster composed of four countries with the highest national innovation capacities in the European Union (Finland, Sweden, Denmark, and the United Kingdom), he obtained two other clusters comprising most of the catching-up member states, as well as some other member states. One cluster comprises the three cohesion states (Greece, Portugal, and Spain) and six less-advanced new member states (Bulgaria, Latvia, Lithuania, Poland, Romania, and the Slovak Republic). These nine states are characterized by weak national innovation capacities. The four more-advanced new member states (Czech Republic, Estonia, Hungary, and Slovenia), together with six old member states (Austria, Belgium, France, Germany, Ireland, and Italy), form a middle-level group of the European Union.

29

This short summary draws on Goldberg and others (2011). See also Roos, Fernström, and Gupta (2005).

30

For an example of how single market reforms in medical devices have promoted innovation in the industry, see Steg and Thumm (2001), who note the limitations imposed by national health systems and the incomplete harmonization in applying single market rules.

31

According to the Business Week ranking of the 50 most innovative companies in the world, only one European company— Nokia—made it into the top 10. Microsoft, Intel, and Google (all Yollies)—in the top 10 of the world’s largest R&D spending—are ranked 5th, 33rd, and 2nd among the most innovative companies. In Europe, Vodafone, BMW, Daimler, Siemens, and Audi rank among the most innovative companies and are among the largest R&D spenders. Only Vodafone is a Yollie.

32

While 25 indicators compose the Innovation Union Scoreboard, only 24 are currently computed, as the indicator on “high-growth innovative enterprises as a percentage of all enterprises” is not yet available.

33

The European Commission JRC-Institute for Prospective Technological Studies collects annual data since 2004 on companies investing the most in R&D worldwide (the EU Industrial R&D Investment Scoreboard). See http://iri.jrc.ec.europa.eu/research/ scoreboard.htm.

34

The sources used for retrieving the age information are mainly company websites. This has been cross-checked with other databases (for example, the Amadeus database provided by Bureau van Dijk, and Véron 2008). To construct the firms’ ages, we used the first year of its creation (ex nihilo). In case of a merger and acquisition (14.9 percent of cases), we used the oldest age of the merged entities.

35

All activities of the firm are consolidated in the scoreboard. We have no information on the geographic or sectoral distribution of firms’ activities.

36

Europe includes the EU27 and countries in the European Free Trade Association. The rest of the world includes Canada (14 firms), China and Hong Kong SAR, China (10), India (12), Israel (8), the Republic of Korea (18), and Taiwan, China (33).


CHAPTER 5

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CHAPTER 6

Labor and Government Chapters 2 and 3 focused on the 26 economies in emerging Europe, analyzing their economic links with the 19 countries in the EU15 and European Free Trade Association (EFTA) economies. In assessing trade and finance, the chapters paid special attention to services, which comprise more than two-thirds of the European economy and are believed to be performing worse than in America and Asia. Chapters 4 and 5 shifted the focus to the 27 member states of the European Union. The link between the chapters on enterprise and innovation was productivity, whose pace of improvement is less than satisfactory. Chapters 6 and 7 widen the scope to all of Europe’s 45 countries. The link between the chapters on labor and government is that the population is aging, which provides the strongest imperatives for rethinking the European model of work and government. Most parts of the world have to contend with aging, but Europe must do so with a model of work that might be least suited to deal with the approximately 50-million-person decline in the workforce expected over the next 50 years, much of which will be occurring in the next two decades. Europe’s work model is marked by unprecedented security for those with jobs, relatively generous benefits for those without, and easy pension eligibility. Chapter 6 finds that this model is making Europe uncompetitive. To address this, most countries in Europe have to increase labor force participation and make it easier for younger people to get jobs that “insiders” have secured for themselves. Collectively, Europe has to decide how to unify its labor market and by how much, and how to attract global talent. Labor has become one of the weak components of the European economic model. Finding a better work-life balance has meant that most European governments are about a fifth larger than their peers and that they spend about 10 percent of GDP more than governments in other parts of the world. Much of this difference is due to spending on social protection (pensions, unemployment insurance, and social assistance). Well-organized governments in Europe manage to keep their economies growing despite the high taxes needed to finance this spending; others have begun to stagnate and accumulate debt. Chapter 7 discusses what helps some economies with large governments— such as Sweden and Finland—keep growing. It requires considerable discipline in delivering social services, making it easy to pay taxes and conform with regulations, and allowing enterprises the economic freedom to compete abroad. Others can make governments more efficient by reforming social protection and social services: this should be the long-term objective. But it is not easy to increase the efficiency of governments. In the meantime, chapter 7 reasons that many European governments must shrink. Their ability to consolidate spending during the 1990s—and the willingness of many to do so during the sovereign debt crisis of 2010-11—should be cause for optimism.

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Chapter 6 Labor In February 2000, the world watched as France instituted the 35-hour workweek, down from the 39 hours expected of French workers and the more than 40 in most developed countries. The reasoning was that because there are only so many hours of work needed, it would be better to share them among more workers. Unemployment in late 1999 was about 10 percent, so cutting the number of hours by about 10 percent might take care of the problem. Economists call this the “lump of labor fallacy.” Another reason was the belief that French workers should be rewarded for their high productivity by allowing them to work less. Researchers had found that the output per hour worked was higher in France than in almost every other country. Getting employers to pay overtime wages for work beyond 35 hours would help labor capture more of the benefits of high productivity. What happened over the next few years? Unemployment did not fall by much, though the new requirements might have encouraged workers to move to smaller firms that were not covered by the law (Estevão and Sá 2006). The 35-hour workweek has since been watered down, but no government has tried to repeal it. Instead, businesses have been given ways around the problem, and the regulations have become more complicated. In the meantime, productivity growth has slowed in Western Europe and sped up in the United States. Between 1990 and 2000, output per hour worked in manufacturing—the sector with the most reliable data—grew at roughly 4 percent a year in both France and the United States. Between 2000 and 2007, it accelerated to 6 percent in the United States, while French productivity growth slowed to 3.3 percent (U.S. Department of Labor 2011).

Is there a European work model? Given demographic changes, how can Europe achieve a stable and more productive workforce? Are employment and social protection practices inhibiting labor participation and efficiency? Is Europe taking full advantage of the benefits associated with internal labor mobility? How can Europe become a global magnet for talent? 291


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The “lump of labor fallacy” might also be responsible for attitudes toward mobility and immigration in Europe. If there is only so much work to divvy up, people from other EU states—not to mention, other parts of the world—should not be allowed in. Prime Minister Gordon Brown, reacting to reports that Italian and Portuguese workers were being hired for construction contracts during the financial crisis, called for “British jobs for British workers.” In contrast, Australia, Canada, New Zealand, and the United States, partly freed from this fallacy by their tradition as centers of immigration, have attracted the best and brightest from around the world. They have succumbed occasionally to the same instincts, even though many studies have found that workers mainly move to places where there are jobs that locals are not willing or able to do (Vedder and Gallaway 1997). But the flow of immigrants serves to inject economic adrenaline in a manner that is less evident in Europe. Although institutions and social norms vary across Europe, the stereotype is that Americans “live to work” and Europeans “work to live.” Few would argue that the two weeks of leave that many workers in the United States get is good for their productivity and for national economic growth. Americans who have traveled or lived in Europe often lament the imbalance between work and life in the United States, and attribute the rise in stress and tensions in family life to the importance Americans give to work. The stubbornly high rates of unemployment since the financial crisis have encouraged skeptics of the “U.S. work model” to question the benefit of its flexibility. These skeptics point out that the U.S. work model seems to deliver a much higher level of inequality and “working poor” than the European work model. One could be forgiven for wondering whether in the years since Europe’s “Golden Age” of growth between 1950 and 1973, Europeans have been drifting to the opposite but equally questionable extreme. In the 1970s, the French worked the longest hours among advanced countries. By 2000, they worked about 300 fewer hours each year—a month and a half less—than Americans. In France, just 1 in 10 people aged 60–65 works; in the United States, the ratio is 1 in 2. Europeans have a choice: work more productively to maintain the European social model or give up a substantial part of it, with major cuts in the generosity of benefits. It will probably end up being a mixture of both. With few exceptions, the labor force will be shrinking everywhere in Europe. Nowhere on the continent is this more apparent than in Europe’s emerging economies. For them, the problem has an added dimension: they have become old before they could become rich. The wealthy part of Europe could tap into its assets to finance part of their benefits. But the way labor markets are regulated in emerging Europe and the comprehensive social entitlements available to households are quickly starting to resemble those in their far wealthier neighbors. For a middle-income country, the combination of a shrinking labor force and EU-type labor market and social institutions could create an insurmountable high debt/low growth trap. As chapter 7 on government will document, spending on pensions is already as much as 15 percent of GDP in some countries such as Serbia and Ukraine. Europe as a whole now spends 10 percent of GDP on pensions, about twice the spending on education. This cannot be good for growth.

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As people cut their work lives in most of Europe, populations in all European countries are aging, shaping their economic potential for years to come. The European Union’s labor force (including the EFTA’s) is expected to decline by about 39 million by 2060. If the Balkans, Turkey, the Russian Federation, Ukraine, and Belarus are included, the decline is about 50 million; the projected increase of 6 million in Turkey’s labor force is more than offset by the decline elsewhere. Only if actual retirement age were to increase substantially (by around 10 years) and participation rates—especially in Turkey and among women—were to increase to levels seen in Northern Europe could Europe offset the decline in the labor force. None of these outcomes, though, would prevent its aging. Europe needs to make its labor force more productive and to attract more productive workers from abroad. Europe is not alone in feeling the force of aging populations. Japan and other developed parts of Northeast Asia already find themselves under the strains of low fertility and increasing longevity. In the Southern Cone of Latin America, Argentina, Chile, and Uruguay also feel the effects of aging. Even China faces this challenge, sooner than it would have if it did not have its one-child policy. But the most “European” features of the work model—unprecedented job security, generous benefits for the unemployed, and easy pension eligibility— make the imperatives created by an aging population most acute in Europe. The first imperative is to counter the shrinking of the labor force. The second is to increase labor force productivity. Europe’s adverse demography also means that its human capital has to be better leveraged. Labor market regulations, interventions, and institutions have to become more “pro-work.” To ease the brakes on growth caused by aging, it is necessary to have labor market regulations that encourage more people to work, to work longer, and to work more productively. Changes that make jobs more contestable will increase productivity. And increasing the productivity of the labor force will require that Europeans become more mobile. But even if Europe can put its human resources to best use, the pace of aging and the decline of the labor force will leave a demographic deficit that can be closed only by tapping into talent from abroad. Europe will have to rid itself of the obstinate “lump of labor” fallacy that impedes smart immigration policy. This chapter aims to answer the most pertinent questions about work and economic growth in Europe. Is Europe’s approach to work making it uncompetitive? Yes. Most countries in Europe are not making the best use of their scarcest asset: workers. European countries must offset the impending labor force decline by increasing the labor force participation of people of all ages, regardless of gender, ethnicity, or socioeconomic background. They must also increase labor productivity, especially by equipping workers with more generic skills that allow them to redeploy their human capital more flexibly across jobs. European countries must improve regulations and interventions so that labor is allocated more efficiently, within and across countries. Europe must change immigration policies to make them respond more to economic imperatives and less to politics.

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This chapter arrives at these conclusions in five steps. Each step involves answering a question: · Is there a European work model? A common approach sets Europe apart. Europe’s approach for balancing economic freedom for employers and social protection for workers is unique. By and large, non-European OECD countries feature less generous protection benefits and more flexible labor markets. In much of Europe, these arrangements do not work well. But the features and performance across countries vary considerably. Over the next decade, two developments—unprecedented in size—will strain the European work model even more. The first is a demographic shift at home, with a quick aging of the population. The second is competition from workers outside Europe, most notably a billion increasingly educated Chinese and Indian workers. Europe must contend with both. · Given the demographic changes underway, how can Europe achieve a stable and productive labor force? Labor markets will need to become more inclusive, with increasing participation among women, youth, the elderly, and excluded groups. None of these measures, however, would prevent the aging of the European labor force. Given the scale and nature of the challenges, Europe needs to make its labor force more productive through better regulation of labor markets and better design of social welfare. In emerging Europe and in parts of southern Europe, skill gaps will need to be closed. Immigration will have to be part of the solution: Europe will have to become a magnet for talented young people from other parts of the world. · Are employment and social protection practices inhibiting labor participation and efficiency? In most parts of Europe, they are. Current policies allow “insiders” to make their jobs incontestable through strict employment protection, while creating considerable work disincentives for “outsiders” through ill-designed social benefits, especially those in low-wage segments. European workers cannot ignore the fact that more than a billion workers have entered the global market over the last decade. Strict employment protection and weak work incentives undermine labor participation and efficiency in Europe. Many governments in the region have been making the labor market more contestable, and others can learn from them. · Is Europe taking advantage of the greater potential for labor mobility arising from economic integration? The short answer is no. Although migration between EU countries is higher than in other parts of the world, intra-EU migration falls short of the European Union’s aspiration of a fully integrated labor market. In addition, internal labor mobility in most countries is low. The explanations (beside the obvious difference in language and culture between EU countries): housing markets are inefficient, wages do not signal labor shortages and surpluses, and the absence of a Europe-wide social safety net makes moving too risky. · How can Europe become a global magnet for talent? With more selfinterested immigration policies. Without changes in labor force participation, the European Union will need about a million immigrants a year for the next five decades to offset its population decline. Immigration policies in

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most European countries focus too much on political factors, such as family reunification, asylum, and human rights, and too little on economics, such as the demands of employers and skill shortages. Though morally laudable, this tilt may make Europe a loser in the competition for globally mobile talent. Some countries have introduced demand-driven residency and work permits, but even their systems struggle to keep up with shifts in shortages and demand for new talent. Immigration policy needs to be complemented with policies that make risk-taking, entrepreneurship, and skills more profitable. Europe is aging and its labor force shrinking. This is not news. But the speed and size of these developments may shock readers, and should motivate policy responses. Labor market regulations, interventions, and institutions are restraining growth, and they must be updated. Education and training systems will need reform to enable workers to move to more productive jobs, with greater ease and to greater profit. Europeans are still less likely to move than people in other parts of the world, and the success of the Single Market for Services depends on their becoming more mobile. Much more can be done to make Europe a global—not just a regional—magnet for talented people. To do all this, Europe’s policymakers will have to convince themselves and their constituents that the rewards of hard work can be shared sensibly without treating labor as a lump.

The European work model If a “European work model” exists, it likely features structures that grant greater power and protection to workers and greater importance to security, possibly at a cost to entrepreneurial risk-taking and individual enterprise. Because any “model” is likely to reflect social norms or values, microdata from the European Values Survey and World Values Survey can be used to examine attitudes toward work. Country-level indicators constructed by the OECD in Paris and the Institute for the Study of Labor in Bonn can also be used to capture structural differences in labor markets and to try to categorize European countries and their non-European peers into work-model types.

Attitudes and values toward work People who study social norms and preferences speak of “work centrality” in reference to the importance that work plays in a person’s life. In societies where work centrality is greater, work ethics rest on the belief that work is desirable and rewarding in its own right (Hirschfeld and Feild 2000). Economists focus analysis of work centrality on differences in working hours, and quite a bit has been written on the differences in hours worked between the United States and Europe. Some theorists relate the increased working hours in the United States to the long-standing cultural differences possibly rooted in America’s puritan Calvinist heritage: “New England’s Puritan settlers avidly struck long-standing religious holidays off the calendar (including Christmas) and thereby increased their total work days significantly” (Alesina, Glaeser, and Sacerdote 2006, p. 46). However, Europeans actually worked longer hours than Americans up until the late 1960s.1 Blanchard (2004) asks whether the large decrease in hours worked in Europe should be interpreted as a growing preference for leisure as productivity increased, or as the result of increasing distortions, such as high taxes on work, early retirement programs, and so on.

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A large body of empirical research finds that taxation (Rosen 1997; Prescott 2004; Davis and Henrekson 2005), unionization and regulation (Alesina, Glaeser, and Sacerdote 2006), and individual preferences (Blanchard 2004) all lead to Europeans’ working fewer hours than people in other countries. When reasonable elasticity estimates are used, however, differences in tax rates and distortions explain only about half the discrepancy between hours worked in the United States and Europe.2 Attributing the fall in hours worked since the mid-1970s to increases in tax rates and regulation alone depends on unrealistic assumptions about utility and the strength of income and substitution effects (Blanchard 2004). In Ireland, average hours worked per year fell from 2,140 in 1970, to 1,670 in 2000 (25 percent), and during this period the Irish economy boomed, with major in-migration, an increase in labor participation rates, and low unemployment, together with a small increase in the average tax rate. Using this example, Blanchard (2004, p.9) argues that “a large part of the decrease in hours per capita over the last 30 years in Europe reflects … a choice that is likely to be made voluntarily by workers”. From analysis of 10 years of microdata from Germany, and country-level data from 12 OECD countries, Alesina, Glaeser, and Sacerdote (2006) conclude that “Europeans seem to be happy to work less and less. Whether they internalize the macroeconomic effects of working less, like relative shrinking of the size of their economies relative to emerging countries, or a decline in the relative prominence of Europe as an economic superpower, is of course a different matter” (p. 55). Several researchers have looked at the relationship between work satisfaction and overall reported happiness. Clark (1997) argues that an understanding of job satisfaction provides “an additional route towards the understanding of certain important labour market behaviours,” and that job satisfaction is “… as close as we are likely to come to a proxy measure of utility at work” (p. 344). There is a strong positive correlation between job satisfaction and subjective measures of happiness, and a negative correlation between annual working hours and job satisfaction (r = –0.65, figures 6.1 and 6.2). A large body of empirical research,

Figure 6.1: Self-reported measures of happiness are positively associated with job satisfaction

Figure 6.2: People who work fewer hours report higher levels of job satisfaction

Source: Torgler 2011, based on European Values Survey and World Values Survey.

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Figure 6.3: In advanced Europe, a clearer tradeoff between preferences for work over leisure

Figure 6.4: In emerging Europe, a tradeoff between work and leisure is less apparent

Source: Torgler 2011, based on European Values Survey and World Values Survey.

for example, shows a strong link between low job satisfaction and quitting behavior, absenteeism, and lower work performance.3 A negative correlation (r = –0.47) between work and leisure preferences is reported by respondents to the European and World Values Surveys (figure 6.3). Sweden is an outlier. Excluding Sweden strengthens the negative correlation (r = –0.75). The broader European neighborhood is different, with a positive correlation (r = 0.44) between the reported importance of work and leisure (figure 6.4). Excluding Albania, the positive correlation increases significantly (r = 0.77). Somewhat counterintuitively, given the rising concern for a tradeoff between work and family life, the data show a strong and positive correlation between the importance of work and that of family centrality (r = 0.76), particularly in newer EU members and countries in the broader European neighborhood. There is a similarly positive—but a substantially smaller— correlation (r = 0.37) for the wealthier countries of Western Europe. Including a wider set of variables to control for individual, household, and other characteristics, regression analysis conducted for this report using the microdata from the European Values Survey and World Values Survey indicates that work centrality is significantly greater in the European Union’s newest members and further in Central and Eastern Europe. The results of this analysis are reported in annex 6.2. Living in emerging Europe rather than in wealthy Western Europe increases the probability that work is viewed as very important by 5–7 percentage points (figures 6.5 and 6.6). It also increases by around 10 percentage points the probability of strong agreement to the statement “Work should always come first.” Perhaps unsurprisingly, part-time workers (those who work less than 30 hours a week) are less likely to care more about work than full-time employees. Again not surprisingly, work is more central to the lives of the selfemployed than it is to full-time employees. Less in line with earlier research, though, analysis of the microdata shows not only a positive correlation between religious activity and work centrality but an observable impact of being Protestant (controlling for religiosity and church attendance) on extreme work

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Figure 6.5: The importance of work is only weakly associated with the importance of family in the EU15

Figure 6.6: In emerging Europe, the importance of work and family are closely associated

Source: Torgler 2011, based on European Values Survey and World Values Survey.

centrality (“work should always come first, even if it means less spare time”). Ideology is important: people who are “conservative” are more likely to rank work higher. By contrast, there is a negative correlation among income, level of education, and work centrality.4

Europe’s policies regulating work are distinct Interest among academics and policymakers in identifying a European work model became apparent in the mid-1990s, as part of broader discussion of a “European social model” to combine economic growth with social cohesion. The European social model distinguished economic policy in Europe from that in the United States. In the early 2000s, identifying and promoting a European work model and European social model became an official EU project, and the Lisbon Agenda was forged as a response to declining growth and increasing unemployment in Europe. The Lisbon objective was to make Europe “the most competitive and dynamic knowledge-based economy of the world, capable of sustainable economic growth with more and better jobs and greater social cohesion by 2010.”5 Since then, there have been several attempts to identify the components of the model—or models—that set work in Europe apart from that in other countries with similar economic and institutional development. The most prominent attempt examines indicators of labor market outcomes and poverty rates. Sapir (2005, p.1), for example, differentiates between the “Nordic” and “AngloSaxon” models (“both efficient, but only the former manages to combine equity and efficiency”) and the “Continental” and “Mediterranean” models (“which together account for two-thirds of the GDP of the entire EU[25] and 90 per cent of the GDP of the [12-member] eurozone” that are “inefficient and unsustainable”). Is there indeed a European model, or rather several distinct ones, and do the differences across work models matter for the functioning of the labor market? To answer this question, the OECD, European Union, and other European

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Figure 6.7: Europe’s approach is distinct—but there are differences within Europe (four work models, based on flexibility and protection, 2007)

Note: Classification is obtained through principal component analysis (see annex 1). Countries with highly flexible labor markets (higher values) are those with low employment protection legislation, low union density, low tax wedge, low minimum wages, and high maximum duration of temporary contracts; countries with high protection (higher values) are those with higher spending on “active” employment assistance programs, social assistance benefits, high replacement rates of unemployment benefits, long duration of unemployment benefits, and annual leave. The value 0 represents the average position in flexibility and protection across all countries in the sample. Source: World Bank staff calculations, based on data on labor regulation, interventions, and institutions from the Institute for the Study of Labor, OECD, and the World Bank. See annex 1 for more information.

countries are mapped—using principal component analysis—into groups based on labor market policies (regulations, interventions, and institutions).6 These policies try to mitigate a tradeoff in the labor market between flexibility and security. Flexibility refers to the costs to firms of hiring, maintaining, and firing workers, which is determined by regulation (employment protection legislation, minimum wage, and maximum length of temporary contracts), interventions (the level of the tax wedge indicating the cost of hiring workers), and institutions (the bargaining power of workers, measured by union density). “Security” refers to the state’s ability to help workers manage labor market transitions and provide them with appropriate safety nets and work conditions (spending on employment assistance programs and social assistance, gross replacement rates of unemployment benefits, unemployment benefit duration, and days of paid annual leave). The principal component analysis yields four different groups of countries along the dimensions of flexibility and protection (figure 6.7). Group 1 comprises countries with fairly high labor market flexibility and worker protection; group 2 countries display low labor market flexibility but high worker protection; group 3 countries have low labor market flexibility and offer little worker protection; and group 4 countries have high labor market flexibility but low worker protection.7 The groups that emerge indicate that there is a European work model, distinct from that of other OECD countries. Based on the extent of labor market regulation and the nature of interventions and institutions, all non-European OECD countries fall into group 4 (flexible labor markets but less generous safety nets and social assistance). Within Europe there is significant variation. The four models do not always coincide with geographic groupings within Europe, especially when considering a set of countries larger than wealthier Western Europe. That said, some

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countries have managed to achieve both high labor market flexibility and high worker protection (group 1). Denmark’s flexicurity model is the most salient example, but Austria, Ireland, Switzerland, and the United Kingdom also fall into group 1. Most of the other EU15 countries, together with Norway, Slovenia, and Serbia, also provide significant worker protection, but their labor markets are fairly rigid (group 2). The majority of transition countries and Turkey are in group 3, with rigid labor markets and low worker protection. Some transition countries—most notably Georgia, but also Albania, Moldova, and Montenegro among others—can also be found in group 4, together with the non-European OECD countries. In general, there seems to be a tradeoff between flexibility and protection in labor markets, with a negative correlation between flexibility and protection across countries. This correlation is even stronger when considering only high-income countries. As discussed above, there seems to be a split among high-income countries, with the EU15 countries concentrating in group 2 and the non-European OECD countries in group 4. This suggests that as incomes increase, countries gravitate toward one of two work models: one that forgoes flexibility or one that forgoes protection. In that sense, transition countries might embark on a path toward one of the two work models. Some already seem to have chosen—Georgia, for example, the high flexibility/low protection model, and Slovenia, the low flexibility/high protection model.

Similar policies can yield different results Similar labor policies can lead to different outcomes. Efficiency is higher in countries with higher than median labor force participation rates and lower than average unemployment rates, youth unemployment rates, and long-term unemployment rates (table 6.1). Countries with structurally high labor force participation rates and low unemployment rates are considered efficient; all others, inefficient.8 Equity is measured by the Gini coefficient in consumption/ income.9 Labor market outcomes across countries can vary with different

Table 6.1: Similar policies can lead to different outcomes (labor market efficiency versus equity, 2007) Low equity

High equity

High “efficiency” in labor markets

Canada, Estonia, Latvia, New Zealand, Switzerland, United Kingdom, United States

Australia, Austria, Denmark, Ireland, Japan, Netherlands, Norway, Slovenia, Sweden

Low “efficiency” in labor markets

Albania, Azerbaijan, Bosnia and Herzegovina, Bulgaria, Georgia, Greece, Lithuania, Macedonia FYR, Mexico, Moldova, Montenegro, Portugal, Romania, Turkey

Armenia, Belgium, Croatia, Czech Republic, Finland, France, Germany, Hungary, Italy, Republic of Korea, Poland, Serbia, Slovak Republic, Spain, Ukraine

Note: Color coding corresponds to the work models as defined in figure 6.7, based on labor market instruments and outcomes: purple (group 1); brown (group 2); yellow (group 3); and black (group 4). Equity classification is based on Gini coefficients for consumption and income and does not reflect equality in opportunities. Source: World Bank staff calculations, based on data from the Institute for the Study of Labor, OECD, and the World Bank; and ILO 2010. See annex 6.1 for more information.

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instruments and institutions, especially in efficiency and equity. Countries that have a similar work model, as defined above and indicated in the table by the color codes, can actually have very different labor market outcomes. What can we learn from this exercise? For wealthy countries, the tradeoff between equity and efficiency might be overstated. Many countries—the Nordic countries and Australia, Austria, Ireland, Japan, the Netherlands, and Slovenia— have achieved equity and efficiency. At the other extreme, many others achieve neither (table 6.1). As reasoned by Sapir (2005), the discussion of the “European social model” and of equity and efficiency in labor markets suggests that in some countries the current model may not be sustainable, and this report concurs. Given the current fiscal and demographic pressures, models that underperform in efficiency have become unsustainable or will soon be. At the same time, many countries with efficient labor markets display low equity, among them many nonEuropean OECD countries such as the United States. The experience of some countries in Europe provides reason to believe that increasing labor market efficiency need not mean a big loss of equity. Countries with both equity and efficiency are among the richest in Europe. These countries arguably have strong institutions in place that cannot easily be replicated. In countries where institutions are not as mature, there might be a tradeoff between equity and efficiency. Europe is not left with many choices.

More—and more productive—workers Looking ahead, Europe will have to counter the aging and shrinking of its workingage population by having workers work more, recruiting more workers from at home and abroad, and critically, making workers more productive by equipping them with the right skills for a competitive global economy. As outlined in the previous section, workers in Europe benefit from the most effective protection against abuse by employers and the most comprehensive job security and nonwage benefits, such as unemployment insurance, paid leave, and retirement pensions, which sustain shorter work hours than in most of the developed world. In many ways, these characteristics set Europe apart from other regions and are a triumph of economic development and liberal democracy. But given changes in Europe and the rest of the world since the end of the continent’s “Golden Age” between 1950 and the mid-1970s (see spotlight one), and the speed of global economic integration since, many features of the European work model are coming under critical scrutiny. These challenges are exacerbated by a shrinking and aging labor force. This in turn reinforces the need to develop human capital that is relevant in a constantly changing labor market, especially among excluded groups, by rethinking education, training, and lifelong learning policies.

The decline of work People in many countries are working less than they used to. As countries have grown richer, people have consumed more leisure, and the average number of hours worked in a year has declined in most middle- and high-income countries (figure 6.8). Where this reduction in hours worked is matched by gains in productivity—the output of the average worker—the decline should be expected and treated as healthy, as in Ireland, Poland, and the Slovak Republic. Yet, the

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Figure 6.8: The decline in hours worked was Figure 6.9: Europe has both faster in Europe than elsewhere in the OECD productivity leaders and laggards (reported average hours worked per year, 2008, 1990 = 100)

(GDP per hour of work, 2008, 1990 = 100)

Source: World Bank staff calculations, based on the OECD Productivity Database.

Source: World Bank staff calculations, based on ILO 2010.

Figure 6.10: The decline in work participation has been faster in Europe

Figure 6.11: Europeans are retiring at earlier ages than they used to

(change in the labor force participation of men ages 15–64, percentage point difference 1980–2008)

(change in the average effective retirement age of men, number of years difference 1965–2007)

Source: World Bank staff calculations, based on WDI.

Source: World Bank staff calculations, based on updated data from OECD 2006.

speed of the decline in hours worked in France, Italy, and Spain since 1995 raises concern when juxtaposed with their modest gains in labor productivity during the last two decades (figure 6.9). Several countries in Europe hold the dubious distinction of having rates of labor participation among the lowest in the world. This is a feature that marks both high- and middle-income countries in the region. The percentage of workingage people who participate in the labor market has fallen at a faster pace in several large European economies than in other member countries of the OECD (figure 6.10). In Europe’s southern periphery, a rare coincidence threatens future prosperity: women have low participation rates and low fertility, adding less to both today’s economic output and tomorrow’s.

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Figure 6.12: The big reduction in the number of young European workers will happen before 2030 (projected changes in labor force, by age group and period, millions)

Source: World Bank staff calculations, based on the methodology described in Koettl 2009; and data from UN 2011.

Europeans have also been withdrawing from the labor market to retire at a much earlier age than previously (figure 6.11). In France and Spain, for example, the effective age of retirement of men has fallen about twice as much as it has in Canada, Japan, and the United States. With the notable exception of the Czech Republic and Germany, where workers are staying active a bit longer than they used to, the trend in Europe is toward earlier retirement, despite efforts of governments in many countries to make qualifying for pensions more difficult. This contrasts with the gentler decline in the effective retirement age of workers in the United States, and sharply with the relative stability in the age of retirement in high-income East Asian countries. Men in the Republic of Korea, for example, are actually working almost six years longer than they were in 1965.

The decline of populations The countries covered in this report—EU countries, EFTA countries, EU candidate countries, and EU eastern partnership countries—will lose 50 million workers between now and 2060.10 Today, the European labor force—employed and active job seekers—consists of 323 million people; in 50 years, it will be down to 273 million, a decrease of 15 percent. Over the next 20 years, the labor force will decrease by 15 million (5 percent). The younger labor force—below the age of 40—will shrink substantially during the 2020s. After 2030, the decline of the European labor force will happen among workers over 40 and gradually slow down. The largest crunch will happen during the 2030s: in that decade alone, the European labor force will fall an additional 14 million people, though mainly among those age 40 or older (figure 6.12). The European Union has been facing an aging crisis since the “baby boom” generation that was born between 1945 and 1960 began retiring in 2005. The largest population cohort, “Generation X,” born between 1960 and 1970, will approach retirement age over the next 15 years. Generation X will start to retire in the 2020s, but thereafter, ever-smaller cohorts of young people will follow, pushing what experts call the “old-age dependency ratio” rapidly downward, so that by 2050 in some European countries there will only be two people working for every person receiving a retirement pension.

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Figure 6.13: Aging in Europe is matched by a “surplus” of working-age people in the Middle East and North Africa (population pyramid Europe, Middle East and North Africa, years)

Source: World Bank staff calculations, based on the methodology described in Koettl 2009; and data from UN 2011.

The decrease in labor force participation varies considerably across European countries. The main reason is that fertility rates in Europe range from around 1.2 to 1.5 in the Eastern, Central, and Southern European countries, to 1.6 to 2.0 in the Benelux and Northern European countries. This is lower than the demographic replacement rate of 2.1 required to keep the size of the population stable. The fall in the labor force will be particularly severe for EU and EFTA countries. Their labor force will decrease by 39 million people (18 percent) over the next 50 years. The other Eastern European countries do not fare much better, with an equally steep decline of 16 percent. The only exception is Turkey, where the labor force is projected to increase 12 percent until 2060. The natural consequence of falling fertility and rising longevity is an increase in the old-age dependency ratio—the number of people older than 65 relative to those of working age (15–64). By 2050, this ratio will double to about 50 percent in Europe, with Spain (68), Italy (66), and Portugal (58) projected to have the highest ratios (Muenz 2007). The projected changes in Europe—especially Southern and Eastern Europe—contrast with trends south of the Mediterranean, where the population is still fairly young (figure 6.13). These trends are seen as complementary and fortunate by some but as a potential threat by others.

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Figure 6.14: To keep the size of the labor force stable, Europeans have to work longer and more productively, but a demographic deficit of young people will probably persist (change in European labor force between 2010 and 2060 by scenario and age group in millions)

Source: World Bank staff calculations, based on the methodology described in Koettl 2009; and data from UN 2011.

Improving Europe’s demographic mathematics Can Europe overturn these trends without increased immigration? Only with radical policy and behavioral changes could Europe counter the shrinking labor force. Yet, even under optimistic conditions, Europe would not be able to prevent the aging of its labor force. First, if participation rates in all countries were to converge to those seen in Northern Europe or, second, if the retirement age were to increase by 10 years across the board, the European labor force would actually increase by 2060 (by 5 percent and 2 percent, respectively; figure 6.14). In a third scenario, if female labor force participation were to converge to that of men, the labor force would still decrease, but only by 5 percent, as opposed to 15 percent in the baseline scenario. None of these scenarios counteracts the loss of young workers due to continually decreasing younger-age cohorts. Under all four scenarios—including the combined maximum scenario—the labor force below age 40 will shrink. In other words, the only large pool of potential additional workers—apart from new immigrants—that Europe could draw from in the future is among the elderly (ages 65 and older). The potential to reverse the shrinking of the European labor force therefore hinges on young, populous countries like Turkey. In fact, in the four scenarios, Turkey would contribute up to 40 percent of any gains in the size of the European labor force and almost all of the younger workers. Without Turkey, European countries would not be able to prevent the labor force from shrinking under any of the scenarios. Improving incentives for work Given the low participation rates in many European countries, there is room to improve and to stem some of the decline of the European labor force. To encourage people to participate, incentives for work must be aligned to ensure that work pays for both the employee and the employer. This could require, among other policy reforms, significant changes on labor taxation and social benefit design. Women constitute 50 percent of the working-age population, and given that they are increasingly more educated—more than men among younger

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cohorts—they represent a large pool of untapped talent. Even if their entry into the market in larger numbers does not produce the payoff in additional workers that increasing the retirement age does, it could have a large productivity payoff. Increasing female labor force participation would require interventions that allow women to better juggle multiple roles by providing, for example, child care facilities and flexible work arrangements (World Bank 2011e). The latter might also play an important role for keeping elderly workers in the labor force by allowing them to phase in retirement on a part-time basis. To increase labor force participation across the board, both employees and employers need the right incentives. Currently, it seems that disincentives for (formal) work are substantial in many European countries, especially for low-productivity workers. For example, Koettl and Weber (forthcoming) show that when comparing formal jobs with informal jobs, the benefits of formal jobs would have to be quite large to offset their costs in terms of taxes, social security contributions, and withdrawn social benefits. A similar result might hold for a comparison between formal jobs and inactivity. This leads to the conclusion that formal (part-time) jobs at low wage levels may not be an economically viable option for low-productivity job seekers in many European countries. For employers, high labor taxation has similar implications as it increases the total costs of labor and makes it less attractive to hire (see also chapter 7 on labor and corporate income taxation). A microeconometric analysis using EU-Statistics on Income and Living Conditions data suggests that there is a negative correlation between the incidence of formal employment and work disincentives at the individual level. Two main levers can make (formal) work pay for low-productivity workers and their employers: decreasing the labor tax wedge at lower wage levels and “smoothing” incentives with changes to social assistance, housing, and family benefits. Regarding the tax wedge, current social protection financing in several countries discriminates against lower-wage earners. Options for reducing the labor tax wedge include incentives linked to wage subsidies, social insurance contribution credits, or so-called “in-work” or employmentconditional benefits—cash benefits or refundable income tax credits conditional on formal employment—for low-wage earners. With regard to the design of social assistance, housing, and family benefits, the key is to keep the marginal effective tax rate in mind when designing eligibility conditions and the ways that benefits are withdrawn. The goal is to reform these benefits toward socalled “smart safety nets,” making social protection benefits more compatible with work. In particular, any additional wage should also increase beneficiaries’ net incomes, including benefits. Otherwise, additional work does not pay, and beneficiaries will prefer not to work at all, to work informally, or to underreport their earnings.11

Developing skills Besides getting more people to work, Europe will have to enable workers to contribute at their highest potential. Doing so requires continual reform of education and training systems. As discussed in chapters 4 and 5, skills are critical for innovation and firms’ growth. Recent studies from OECD and developing countries spotlight the

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Figure 6.15: Better-educated people are more likely to participate in the labor market (percentage point difference in labor force participation rates between those with tertiary education and those with less than upper secondary education, 2010)

Source: World Bank staff calculations, based on Eurostat.

Figure 6.16: Skills are an important constraint for many firms in emerging Europe (distribution of firms that consider skills to be a major or very severe constraint, 2008)

Source: Sondergaard and Murthi 2011.

importance of skills—cognitive, socioemotional, technical—in determining productivity. For example, Hanushek and Woessmann (2011) have shown that cognitive skills (proxied by Programme for International Student Assessment scores) explain a sizable part of the variation in growth rates observed in OECD countries, including Western Europe.12 In fact, the evidence suggests that generic skills also have substantial growth payoffs, even in advanced economies. Unsurprisingly, skills are at the center of the policy agenda of the European Union and Europe at large, as reflected in the European Union’s growth strategies (Lisbon Agenda, Europe 2020) and numerous strategic and policy documents (European Commission 2010b; Sondergaard and Murthi 2011). Skills include not only technical ability, but also generic cognitive skills (literacy, numeracy, problem solving) and generic noncognitive skills (socioemotional and behavioral attributes such as teamwork, self-discipline, and perseverance). A solid base of generic skills seems to be a prerequisite for further acquisition of technical skills, whether through post-secondary education or on the job.13

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Further, the foundation for the development of generic skills is built early in life and during adolescence and hinges on having access to adequate nutrition, nurturing environments, and high-quality basic education (World Bank 2011b). Efforts by the OECD and the World Bank to measure the availability of and demand for cognitive and noncognitive skills are underway.14 Skills not only matter for economywide productivity but also individual labor market outcomes. Heckman, Stixrud, and Urzua (2006) document the evidence for the United States, while Brunello and Schlotter (2011) review the emerging literature for Western Europe. Differences in labor force participation rates between those with tertiary education and those with less than upper secondary education range from about 8 percentage points in Iceland to 28 percentage points in Turkey (figure 6.15). In other words, in Turkey the higher-educated are 28 percent more likely to participate than those with lower education. This could be of particular importance for excluded groups. In Bulgaria, Romania, and Serbia, the share of the Roma working-age population with at least some secondary education is 60 percentage points lower than that of the non-Roma. Not surprisingly, there are also significant gaps in the labor force participation of the two groups, especially among women. In some countries, the Roma could be a quarter of labor market entrants in the near future. Helping them become more productive is not only a matter of social inclusion, it could also increase economic growth (World Bank 2010). Firm surveys show that skills have in recent years become increasingly binding for productivity and job creation in emerging Europe. Skilled-labor shortages have become the second-most commonly reported constraint to growth in the enterprise surveys across all countries in Eastern Europe, behind only tax rates (Sondergaard and Murthi 2011). On average, 30 percent of firms considered education and skills to be a major or severe constraint in 2008 (figure 6.16). Upwards of 40 percent of firms were dissatisfied with the availability of skilled workers in the former Yugoslav Republic of Macedonia and Ukraine. These surveys have found that in addition to technical skills, the lack of noncognitive generic skills appears especially binding (World Bank 2009 and Rutkowski 2010). Also in OECD countries and some middle-income countries, noncognitive skills are as important as cognitive and technical skills in firms’ hiring decisions.15 Despite overall success in increasing student enrollment, the quality of education needs to be improved. The picture of education quality in Europe is diverse. Outcomes—as measured by the Programme for International Student Assessment—appear particularly poor in Azerbaijan, Bulgaria, Montenegro, and Romania, which have students in early grades that underperform relative to the country’s level of development (figure 6.17). For another group of countries (Bulgaria, Croatia, the Czech Republic, and FYR Macedonia), the performance in cognitive tests worsened between 2006 and 2009. Worrisome for labor market outcomes, upper secondary and tertiary education students may be graduating with the wrong skill sets (Sondergaard and Murthi 2011). There is evidence that after the transition, the obsolescence of technical skills was not addressed and that vocational education systems have not performed well. As a result, employers today often assert that it is difficult to find graduates with adequate technical skills.

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Figure 6.17: Cognitive skills are adequate in most European countries (reading competency of 15-year-olds on the Programme for International Student Assessment 2009 versus income)

Note: The figure shows a log-linear regression line representing countries’ predicted reading score in the Programme for International Student Assessment on their GDP per capita. The blue line is the OECD mean reading score. Source: Sondergaard and Murthi 2011.

Effective policy interventions can address many of these problems. As discussed in a recent World Bank report, interventions should focus on overcoming failures in information and quality assurance. Countries in emerging Europe have to reorganize their school networks to deal with shrinking student populations. Countries should also rethink their training and education systems to avoid specialization in narrow (technical) fields too early in a student’s career. Countries should also ensure that preschool and basic education curricula and pedagogic practice pay adequate attention to the development of cognitive and noncognitive skills. The experience with related reforms and interventions in Europe and the rest of the world can offer useful lessons. Lifelong learning will become increasingly important given the demographic trends (Chawla, Betcherman, and Banerji 2007; European Commission 2006). In short, it is the formation of the right skills rather than diplomas that should be the focus of reforms (Sondergaard and Murthi 2011). To that end, more information is needed on the learning and employment outcomes of students and graduates.

Making jobs more contestable Economists view competition much like most people view exercise. At some abstract level, we all know it is good for us, but go to surprising lengths to avoid it. Economic agents—individuals or enterprises—are constantly hunting for an opportunity to monopolize a market. Just as we accept that exercise is a good thing, paying ever-higher fees to go to the gym and be put through a punishing workout by a personal trainer, as taxpayers we finance government agencies to eliminate uncompetitive practices. The rationale for the government’s role in the labor market is much the same: to protect workers from a lack of competition among employers for their labor and human capital.

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Yet, these policies are from a time in Europe’s history when large-scale manufacturing dominated economies, and a few (and in some places even single) employers could set the price of labor and manage their human resources with impunity. Images come to mind of the abuses in Victorian-era Britain, where workers toiled for 14-hour shifts and could be dismissed at the employer’s whim. The balance of information and power between those who seek jobs and those who offer them has shifted considerably in the decades since. And along with this shift, the changing economic structure of most European countries—away from large-scale industry toward varied services— has made the labor market more “atomistic.” As more and more services become tradable (see chapter 2), it is harder for employers and workers to avoid competition. But labor market policy has not kept up with these changes. The policies prevalent in Europe—and parts of the world that Europeans trade and compete with—make its labor markets more difficult to contest, especially for new, younger entrants. This lack of contestability may discourage some from entering the labor market at all, impede the efforts of others to match up with employers who could most benefit from their skills and attitudes, and increase the incidence and duration of unemployment. Recent evidence shows that in countries where the labor market is less contestable—especially due to restrictions on dismissal—individuals and firms are more likely to take their activities into the shadows of unregulated and untaxed markets, depriving the state and society of public goods and holding back economies from fulfilling their growth potential.

Box 6.1: Is a flexible labor market necessary for successful monetary union? For some countries, the last few years has been difficult, being part of a currency union during, particularly one as large and economically diverse as the eurozone. Depreciation could have come in handy, as it did in the Czech Republic and Poland. But for euro area members and those with currencies pegged to the euro, this was not an option. For the few such as Latvia that made it easier to adjust wages downward, being linked to a strong currency was less of a problem. The 2008 crisis and contraction put these strains into sharp relief. But tensions had been growing long before. Differences in real unit labor costs (RULCs) between euro area members have persisted since the start of the Economic and Monetary Union, widening during the crisis. RULCs reflect prices and nominal labor costs, and on both indicators euro area members have diverged. This is most noticeable in shifts in nominal unit labor costs since 2003: while in Germany the growth rate in nominal unit labor costs has been well below the euro area average, reflecting a stronger wage discipline, in Greece, Ireland,

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and Spain nominal unit labor costs have increased noticeably compared with the average. Widening or persisting differentials in RULCs are at odds with the expectation that adopting a common currency—and hence a common anchor for inflation—should have facilitated convergence in prices and wages across euro area countries, narrowing growth differentials in RULCs. Three reasons seem to explain the divergence: • Technological factors, with capital accumulation and increases in the price of intermediates both leading to higher growth in RULCs. This would be consistent with capital and labor not being easy substitutes. • External factors, captured for example by the degree of openness, leading to downward pressure on RULCs due to both the disciplining effect on wage increases and the positive impact on labor productivity as a result of more access to new technologies and markets.

• Institutional factors, reflecting the degree of competition in product and labor markets. Higher replacement rates in unemployment benefits and wage bargaining centralization are associated with higher RULCs as they strengthen the bargaining power of workers; stringent labor regulations for hiring and firing workers could be associated with lower RULCs because they come with lower employment. Since the divergence in labor costs across euro area members is partly the result of structural differences in the labor and product markets, better policy and institutional alignment could reduce the gaps. With a single currency and low inflation, closing the gaps in RULC growth can be painful, requiring wage cuts and possible unemployment increases. A smaller gap is needed for lagging countries to be competitive within the eurozone; given Europe’s increasing integration with the global economy, to remain competitive the convergence in RULCs will have to be downward. Source: Based on Lebrun and Pérez 2011.


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Does it matter if Europe’s labor markets are inflexible and uncontestable? The broad divergence in the speed with which employment rates are recovering in the wake of the global financial crisis and recession suggests that it does. In countries that forgo the macroeconomic shock absorber offered by a flexible exchange rate (that is, all current euro area members and those preparing to join by tying their currencies to the euro), the impact of a sudden fall in demand on the product and labor markets can be mitigated if wages are allowed to fall, hours are flexible, and workers at the margin can be dismissed (World Bank 2011c; box 6.1). When examining the relationship between labor market structures and outcomes, it is helpful to distinguish between regulations, interventions, and institutions. Regulations set work’s legal parameters, in the form of a minimum wage and/or restrictions on dismissal. The state deploys interventions to correct market failures, such as the inability of private financial markets to viably insure the risk of unemployment (unemployment insurance) and differences in how much information employers and job seekers have (job-seeking assistance). Institutions are the structures and agreed procedures for exerting influence and carrying out decisions. For the labor market, the best example is the space afforded in the legal code of most countries for collective bargaining through labor unions.

Hiring and firing workers is costly A legislated minimum wage increases labor costs for firms and can dissuade them from offering employment to workers whose marginal productivity does not exceed the minimum. This effect will be stronger for workers with lower productivity, especially younger, unskilled, less experienced workers (Montenegro and Pagés 2005). Priced out of jobs on the formal (regulated and taxed) market for labor, they can join those genuinely unemployed, take an informal (unregulated and untaxed) job, or pretend to look for a job while

Figure 6.18: Minimum wages in the newest EU member countries are increasing faster (level and growth, 2000-07)

Note: Dark blue bars represent Western Europe, and light blue emerging European economies. Source: Fialová and Schneider 2011.

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Figure 6.19: Employment protection is converging through liberalization in more rigid labor markets (level and change, 1999-2007)

Note: Dark blue bars represent Western Europe, and light blue emerging European economies. Source: Fialová and Schneider 2011.

working informally. But a minimum wage might also motivate workers to increase productivity or persuade job seekers and some outside the labor market to hold out for a job on the formal market, even if plenty of informal employment is on offer (Rebitzer and Taylor 1995; Manning 1995). All new members of the European Union introduced legislated minimum wages. Although several older members do not have legally binding minimum wages, an effective minimum wage is secured through the collective bargaining process in Austria, Denmark, France, Germany, Italy, and Sweden. Generally, legislated minimum wages in the European Union’s new members are considerably lower than the legislated or effective minimum wages in the older member states. Over the past decade, however, these have been on a clear upward trend. Since 2000, the minimum wage as a percentage of average wages has risen fastest in Bulgaria and the Czech Republic (figure 6.18). A second common set of labor laws, employment protection legislation (EPL), restricts employers’ ability to dismiss workers—reducing flows into unemployment but also out of it. Strict EPL can slow new employment if restrictions on dismissing workers make employers wary of hiring someone new. For this reason, restrictions on dismissal can increase unemployment, the duration of unemployment, and the attraction of fixed-term contracts. Past a certain threshold, it can even cause employers to turn to the untaxed, unregulated labor market. Beyond affecting flows into and out of employment, EPL creates an “insider-outsider” divide. Those who have a protected job (“insiders”) are relatively guarded from losing it, while the inactive and unemployed (“outsiders”) find it more difficult to gain employment. EPL changes the distribution of jobs, with important implications for first-time job seekers, youth (especially), women, the disabled, and other disadvantaged groups. Using the OECD’s measure of the strictness of employment protection (OECD 1999, OECD 2004, and Venn 2009)—and its application by Lehmann and Muravyev (2010) to non-OECD European countries—the least restrictive conditions for employers are in Denmark, Hungary, Ireland, and the Slovak

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Republic. France, Greece, Portugal, and Spain have the most restrictive regulations. In Austria, Greece, Italy, Portugal, and the Slovak Republic, employment protection has been noticeably relaxed. Partly, this relaxation has come in the form of more temporary contracts, especially in Italy and Spain (box 6.2). But over the same period, Hungary, Ireland, and Poland have tightened their EPL. EPL in the European Union’s newest member states is lower than in the older members, but there has been convergence driven both by liberalization in parts of the west and growing restrictions among members in the east (figure 6.19). Lithuania and Slovenia had the most restrictive legislation, though Slovenia has liberalized recently. Romania, by contrast, recently tightened its EPL and, after Portugal and Spain, now has the most restrictive regulation.

Box 6.2: Do temporary contracts make labor markets flexible? During the past decades, employment protection legislation (EPL) reform in Europe was mostly “partial” or “two-tier.” In the mid1980s, several European countries, with high levels of EPL, introduced temporary contracts to increase labor market flexibility. Many countries deregulated the use of temporary contracts substantially but maintained strict protection for permanent ones. There is substantial evidence on these reforms, based largely on the Spanish experience (Dolado, García-Serrano, and Jimeno 2002; Bentolila, Dolado, and Jimeno 2008). Because temporary contracts involve much lower firing costs, both in severance payments and legal costs, their incidence increased significantly. Spain is a good example of labor market dualism, with the highest incidence of temporary contracts. In 1984, a two-tier EPL reform liberalized the use of temporary contracts. Spain registered the most rapid growth in temporary jobs, from 11 percent of total employment in 1983 to about 35 percent in 1995 (Güell and Petrongolo 2007). But Spain is far from unique. According to the European Commission (2010a), EU member states that introduced two-tier EPL reforms have seen an increase in temporary employment since the mid-1980s. Countries with relatively less stringent regulations for permanent contracts— like Denmark, Ireland, and the United Kingdom— do not show any trend increase in the incidence of temporary employment. Temporary contracts affect young workers more. In most EU member states, 40 percent of young people (ages 15–39) are on temporary contracts, especially among those under

25 years of age. The share of temporary employment among workers in the 15-to-24 age group ranges from more than 50 percent in countries like France, Germany, Poland, Slovenia, and Spain to less than 20 percent in Bulgaria, the Czech Republic, Latvia, Lithuania, Romania, the Slovak Republic, and the United Kingdom. Temporary contracts have both positive and adverse effects. They can help firms to evaluate workers’ suitability for jobs. In that sense, temporary jobs could act as a stepping stone to more stable jobs. Temporary contracts could also act as a shock absorber, protecting firms from temporary demand fluctuations by avoiding costly adjustments to their core labor force. Boeri and Garibaldi (2007) and Boeri (2011) show that the “flexibility at the margin” provided by temporary contracts increases both hiring and firing rates for newly created jobs, as firms try to restrict firing costs through reduced conversion. Of course, temporary contracts can be an easy way for firms to reduce labor costs, substituting temporary for permanent workers (Layard 2005). Temporary contracts can help make labor markets more dynamic. Two-tier EPL reforms have dramatically raised the proportion of new recruitments of temporary contracts (Cahuc and Postel-Vinay 2002). Bover and Gómez (2004) found that in Spain, exit rates from unemployment into temporary contracts were 10 times larger than exit rates into permanent ones between 1987 and 1994. Using a sample of large Spanish firms in 1993–94, García-Serrano (1998) found that

turnover rates varied by type of employment contract. In particular, a rise of one percentage point in the share of temporary employment increased flows from employment to unemployment, unemployment to employment, and employment to employment by 0.26 percentage points. Bentolila, Dolado, and Jimeno (2008) found that, insofar as the use of temporary contracts implies a rise in the hiring rate, they have helped decrease long-term unemployment, especially in periods of high growth. Despite helping to create labor market dynamism and employment, temporary contracts can adversely affect productivity and investment in skills. Greater turnover and low conversion rates can reduce incentives to invest in firm-specific human capital (Dolado, García-Serrano, and Jimeno 2002; Bentolila, Dolado, and Jimeno 2008). Güell and Petrongolo (2007) argue that the negative impact of temporary work on vocational training depends on whether temporary contracts are used mainly to lower wage costs or to screen for entry-level jobs. Boeri and Garibaldi (2007) found that the share of temporary workers in Italy has a large negative impact on firm-level productivity growth. The authors argue that rising employment, in the aftermath of two-tier EPL reforms, led to falling labor productivity through decreasing marginal returns for labor. In conclusion, the Spanish experience is mixed. It suggests that the two-tier EPL reform led to an increase in worker turnover, and a reduction in long-term unemployment. But it also is associated with a fall in investment in firmspecific human capital and productivity.

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Figure 6.20: The wedge created by income taxes and social insurance contributions is highest in Italy (average personal income tax and social security contributions)

Note: Social security includes both employee and employer contributions. Dark blue bars represent Western Europe, and light blue emerging European economies. Source: World Bank staff calculations, based on the OECD Tax Database.

Figure 6.21: Labor costs have been rising quickly in the EU’s newer members (average hourly labor costs, calculated as cost of labor divided by hours worked)

Source: World Bank staff calculations, based on Eurostat.

Figure 6.22: In Emerging Europe, the tax wedge for lowest-wage earners tends to be high (wage level at which tax wedge is binding, percent of average wage)

Note: The scatter plot depicts the wage level where the tax wedge starts to increase (x-axis) versus the tax wedge at 1 percent of average wages (y-axis). Hungary, the Netherlands, and Serbia feature falling tax wedges at low-wage levels and are not depicted, just like Bulgaria, which has a at tax wedge. Austria, Belgium, and Canada have partly negative tax wedges at low wage levels, especially for families, and Canada is excluded. The new member state countries of Eastern Europe are in light blue. Source: Koettl and Weber forthcoming.

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Figure 6.23: In much of the European Union, membership in labor unions has been declining (percentage of workers who belong to a labor union, 2000-07)

Note: Dark blue bars represent Western Europe, and light blue emerging European economies. Source: Fialová and Schneider 2011.

Labor market interventions—“active” labor market programs such as training and job search assistance, and “passive” unemployment benefits such as unemployment insurance and other forms of social insurance—are common in the European Union, including the new member states. These interventions are typically financed directly through a tax on earnings. In much of Europe, the cost of these interventions raises the cost of labor, creating a “tax wedge” between what employers pay for work and what workers take home (figure 6.20). The largest component of the tax wedge comes as personal income tax and contributions to pensions and health insurance, but financing these interventions also adds to labor costs. A higher tax wedge contributes to higher labor costs in the formal sector and can dissuade employers from taking on workers or increase demand for informal ways of contracting workers (Davis and Henrekson 2005; figure 6.21). Not only is the level of labor taxation important, but also how it progresses over income levels. In the new member states of Eastern Europe, labor taxation tends to be high on low-wage earners, potentially making it more difficult for them to work in the formal sector (figure 6.22). Moreover, the wage level at which labor taxes start to increase is also fairly high, making labor taxation less progressive in these countries. When well designed and administered, such programs may improve labor market performance. Active programs that enhance skills or eliminate information asymmetries that delay or frustrate matching in the labor market should shorten the job search period. Active programs might lower the search and training costs of firms and indirectly subsidize the creation of better jobs. Passive programs, such as unemployment benefits, can remove the urgency of finding a new job and improve the quality of matches. But the record of active programs is mixed at best, and if unemployment benefits are overly generous or poorly designed, they can lower peoples’ motivation to look for and accept a job. Finally, it is difficult to isolate institutions that impact only the labor market from those that also shape other social and economic interactions. One is especially relevant: collective bargaining as proxied by the strength of labor unions. The impact of labor unions is felt largely through the importance of minimum wages, EPL, and active and passive interventions already discussed

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(figure 6.23). But strong labor unions can shape the labor market beyond the direct impact of regulation and interventions. For example, even where the share of the total labor force that is unionized is small, it may be high in the public administration and the provision of essential services including education, health, and transportation. The labor code in some countries even augments collective bargaining and the power of unions: the salaries and benefits that unions succeed in negotiating for their members become binding for others in regulated employment, whether they are members or not.16

Work is being pushed out of (regulated) markets Taxes and regulations can create incentives for people to consume more “own-provided” services at home and for workers and employers to transact “in the shadow” on the unregulated and untaxed market (Rosen 1997; Davis and Henrekson 2005). The likelihood that they will transact informally increases where a government’s capacity to enforce regulation is low. Conventional textbook models show how restrictions on firing, a relatively high minimum wage, and the taxes on labor that finance active and passive assistance programs can segment insiders who benefit from the labor code from outsiders who cannot. Less conventionally, in countries where governments fail to provide or sustain high-quality services, employers and workers can become disenchanted with complex labor regulation and consider taxes and compliance efforts not worthwhile. There is evidence that high taxes increase nonmarket or home production of services in Northern Europe, and they push legal market activities into the informal market in the south (figure 6.24).

What helps, what hurts Because there is no simple mapping between labor market outcomes and social protection policies, a more rigorous analysis of the links between the two is needed, controlling for country characteristics. Country-level data from the OECD, the Institute for the Study of Labor, the International Labour Organization, and the European Bank for Reconstruction and Development can be used to assess how the institutions, regulations, and interventions discussed above are associated with the performance of Europe’s labor markets relative to those

Figure 6.24: Informal self-employment is most prevalent in Greece, Italy, Portugal, and Spain (unregulated, untaxed work, percentage of labor force)

Source: World Bank 2011a, based on Hazans 2011a.

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Figure 6.25: In Europe, active labor programs are associated with higher labor force participation

Figure 6.26: Rigid employment protection legislation is associated with lower employment rates

(percentage point change in the working-age population working or searching for a job: estimated impact of a unit change in statistically significant explanatory variables)

(percentage point change in employment rate: estimated impact of a unit change in statistically significant explanatory variables)

Note: Only coefficients significant at the 1 percent and 5 percent levels are shown in the figure. Full results and more information are available in annex 2. Source: Fialová 2011.

Note: Only coefficients significant at the 1 percent and 5 percent levels are shown in the figure. Full results and more information are available in annex 2. Source: Fialová 2011.

Figure 6.27: Rigid laws and high taxes are associated with higher unemployment, active labor programs with lower unemployment (percentage point change in unemployment and long-term unemployment rates: estimated impact of a unit change in statistically significant explanatory variables) Change in unemployment

Change in long-term unemployment

Note: Only coefficients significant at the 1 percent and 5 percent levels are shown in the figure. Full results and more information are available in annex 6.2. Source: Fialová 2011.

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of other countries.17 This approach also complements the firm-level analysis provided in chapter 4, focusing on country-level legal and institutional variables, which are not captured in that analysis. The cross-country analysis also complements microeconomic evidence at the individual level when analyzing disincentives for formal work originating in the tax and benefit system, as discussed in the subsection on work disincentives. Fialová (2011) examines the impact of policies on four indicators of labor market performance: the activity rate (AR); employment rate (ER); unemployment rate (UR); and long-term unemployment rate (LTUR). This is done for three sets of countries: the European Union and other OECD members,18 the European Union,19 and EU new member states, accession countries, and others in the European neighborhood (figures 6.25–6.27).20 With regard to employment protection, stricter EPL is mostly associated with lower participation rates—except in Western Europe—and higher unemployment rates. Similarly, higher labor taxation is negatively correlated with labor force participation—with the exception of the new member states—and positively correlated with unemployment rates, though the latter result is less robust. High labor taxation, associated with long-term unemployment, appears to be a major problem in Europe. Overall, the strictness of EPL and high labor taxes lower the employment rate.

Box 6.3: Denmark’s “flexicurity”: increasing contestability, the gentler way Every year, about 20 percent of Danes lose their jobs. But they do not lose their incomes. Unemployment benefits replace close to two-thirds of their earnings, and the government helps them find work. Flexicurity, the combination of flexibility for employers and income security for workers, has been in place since at least the 1970s, but it has evolved over time as the active component has been strengthened. And it seems to work well. Between 1995 and 2008, Danish unemployment rates averaged 4.9 percent, while the rest of the EU15 suffered rates close to 8.5 percent. Denmark has been getting a lot of attention among policymakers. Danish employment laws have evolved from the “Gent system,” when labor and trade unions, not the government, paid unemployment benefits. In the 1970s and 1980s, unemployment rates remained high, while those without jobs got good incomes. The arrangements became too expensive and were reformed in the 1990s. The new approach is sometimes called the “Golden Triangle,” because it added both generous unemployment benefits and active labor market programs to flexible hiring and firing laws. • The first component, flexibility of firing and hiring, remained practically unchanged. The OECD employment protection legislation

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index for Denmark fell from 2.4 in 1983 to 1.5 in 2009; the OECD average is 1.9. Relatively flexible laws work in Denmark because the country has a history of self-regulation by employers and unions, going back to the “September Compromise” of 1899, which set rules for resolving labor disputes.

for more than a year) decreased from a third of total unemployment in 1994 to a tenth in 2009. Despite liberal firing and hiring practices, employment has not fluctuated too much in response to output variability. All this is good.

There are some qualifications. First, though official unemployment has fallen, there is a • The second part of the Danish model is gap between actual unemployment (adding unemployment insurance financed from up the unemployed, those in “activation,” and contributions and taxes. Membership is early retirees) and official statistics. Second, voluntary, but it covers around 80 percent it is difficult to assess how much of the fall in of the labor force. Benefits last up to four unemployment is due to flexicurity on its own. years, and replacement rates cannot exceed Economic performance matters too: active 90 percent of wages, capped currently at labor policies are useless if the economy is not €2,173 a month. After four years of benefits, producing jobs. Finally, the already high fiscal recipients have to switch to social assistance, burden can become enormous in a protracted which means a reduction of between 20 and slowdown. The Danish model costs 4.5 percent 40 percent of their benefit income (Andersen of GDP in terms of active and passive labor and Svarer 2007). market measures. And Denmark spent 2.6 percent of GDP for labor market programs in • The new system uses active labor market 2008 (a good year), compared with 1.4 percent programs like job search assistance and for the OECD as a whole, 1.5 for Sweden, 2.2 for training to nudge the unemployed back to Finland, and 2.3 in the Netherlands. The Danes work. The spending on these programs is have flexicurity because of their history and sizable: out of €13 billion spent on labor can afford it in part due to high participation market programs in 2010, about 75 percent rates of 81 percent; the OECD average in 2009 was on active instruments. was 71 percent. Those wishing to learn from How well does flexicurity work? The the Danes should note this. unemployment rate dropped from 10 percent in 1993 to 3.3 percent in 2008. The incidence of Source: Andersen and Svarer 2007; Bredgaard and Larsen 2007; Hansen 2010; OECD 2010. long-term unemployment (being out of work


CHAPTER 6

Minimum wages are also negatively correlated with participation rates. This appears counterintuitive: the prospect of a higher wage should entice people into the market, not keep them out. But workers priced out of jobs as a result of minimum wages might be discouraged from further participating in the labor market—especially younger people and women. The minimum wage is also associated with higher unemployment rates—especially long-term unemployment rates—and lower employment rates. Unionization is positively associated with participation in the labor market and employment rates, and seems to reduce long-term unemployment (in the European Union). Spending on active labor market programs is associated with higher rates of participation, lower unemployment rates, and higher employment rates. The relationship between the generosity of passive labor market programs and labor market outcomes appears more complex: while generosity tends to increase participation in Europe, it appears to have the opposite effect in non-European OECD countries. The generosity of unemployment benefits is also associated with lower unemployment and higher employment in Europe.21

Box 6.4: Germany’s Hartz reforms: modernizing social welfare and unemployment benefits Germany experienced high unemployment rates of almost 10 percent between 1993 and 2004. By contrast, U.S. unemployment was about 5 percent. By 2004, almost 4.5 million Germans were unemployed according to the Federal Labor Agency. Less-skilled and older workers had higher unemployment rates; vocational school graduates and high school dropouts had unemployment rates of about 18 percent.

• Public employment services and social welfare centers adopted results-based accountability and outsourced services through competition between public and private providers. Employment offices were (partly) merged with social welfare units and converted into centers that provided job search assistance, social services, and benefit payments.

the reform. But evaluations have found limited impact on mini-jobs.

The Hartz reforms helped reduce unemployment. Despite the crisis, Germany’s unemployment rate today is about 7.5 percent, lower than the U.S. rate of more than 8.5 percent. Many of the newly introduced parttime and temporary jobs have served as a bridge to regular jobs. But the reforms might • Unemployment and social benefit levels also have reduced the income of low-wage and duration were reduced. Eligibility for earners, which has declined 16–22 percent over In February 2002, a commission suggested subsistence allowances was changed the last decade. Net real monthly income of ways to modernize the labor market. according to a person’s ability to work rather workers in mini-jobs declined from €270 in Volkswagen’s personnel director Peter Hartz than previous history of contributions. 2000 to €211 in 2010, while income of workers headed the commission, which comprised Benefits were cut if recipients did not meet in midi-jobs declined from €835 to €705. This business executives, trade unionists, their responsibilities. is mainly due to an increase in the number of politicians, and scientists. No economists were people in temporary work and part-time jobs. • Wage subsidies and start-up grants were invited to join. provided to entrepreneurs. Jobs with The reforms raise several questions. First, The commission proposed a three-part reduced social security contributions were given the difficulty of comprehensive labor reform strategy: improve employment introduced (“midi-jobs”), and the regulations reforms, does a partial liberalization targeted services and active labor market programs, for jobs exempt from such contributions at some groups or sectors work? Second, reform unemployment and social assistance were reformed (“mini-jobs”). The objective do allowances in the labor code for more benefit programs, and foster employment by was to lower the cost of hiring low-skilled flexible forms of employment lead to a deregulating the labor market. workers. “two-tier” market and a legally sanctioned underclass of workers? Third, do flexible and The reforms were implemented between Between January and October 2006, the temporary forms of employment serve as a 2003 and 2005. They modernized public number of claimants in jobs requiring social step toward advancement, or are people who employment services and social welfare insurance contributions rose 47 percent. enter through a midi- or mini-job experience centers, modified existing active labor The number of claimants working part-time scarred in ways that limit their future programs, and introduced new active grew 30 percent, and the number in marginal options? Germany’s experience appears to be labor programs. The reforms changed the employment (“mini-jobs”) rose 14 percent. promising, but these doubts will be raised in institutional and legal framework for the rights Workers who had survived on low wages countries that try to adopt strategies similar to and responsibilities of the unemployed and the without income support could now supplement the one proposed by the Hartz Commission. beneficiaries of social assistance. Employment their incomes with Hartz IV benefits. The reform of temporary work regulations Source: Zimmermann 2007; Goethe Institut protection was reduced for parts of the increased employment in fixed-term jobs after (2007); Goebel and Grabka (2011). labor market.

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When it comes to untaxed and unregulated work in the “shadow economy,” World Bank (2011a) found that when taking a country’s development into account, EPL is associated with larger shares of shadow economy in GDP and greater labor informality. In the southern members of the European Union, where EPL is the most restrictive, all but the highest educated new entrants to the labor market are restricted to part-time and informal work. The need to keep EPL sensible is at the core of Denmark’s “flexicurity” model, which shifts protection away from jobs to the incomes of people who lose employment, with efforts to get them back to work through training, job-search assistance, and help with starting businesses (box 6.3). These “active” intervention measures seem to improve performance and lower informal employment in OECD member countries and Northern and Western EU member countries. Active programs also lower informal self-employment (Hazans 2011b; World Bank 2011a). Germany has been getting attention for its attempts to liberalize a section of its labor market and to motivate people with strong incentives to remain idle (people supported by unemployment and social assistance benefits; box 6.4). Although Germany’s approach may be all that can realistically be achieved given the controversial nature of labor market reform, it has raised questions about the sustainability and welfare of what could be a working “underclass” in jobs with less protection and even lower wages, which are still subsidizing a relatively privileged class of tenured workers.

Labor mobility—the freedom forgone There are many reasons why labor mobility matters for productivity and growth. A country with a more mobile labor force uses available resources more effectively and is more likely to better match its human capital to other factors—both those that are more fluid such as capital, and those that do not move at all such as land. Recent work indicates that labor mobility is critical for social cohesion and the improvement of welfare in lagging regions.22 When people move, they create links between places where economic activity is densely concentrated and those where it is not. These links become channels for resources that flow back to peoples’ places of origin in the form of knowhow and remittances, sustain the welfare of family members left behind, and

Figure 6.28: Europeans are less mobile (labor mobility, share of working age population that has moved, 2000-05)

Source: Bonin and others 2008; and OECD 2005 and 2007.

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CHAPTER 6

Figure 6.29: Europeans—especially in the east—are less internally mobile (internal migration, percentage of population, by size of area)

Note: Countries display differing internal migration rates, depending on the size of the unit of measurement. For example, internal migration measured at the village level (movements from one village to another) is much higher than migration measured across larger geographic areas, like districts or regions. The line represents the log trend. Source: World Bank staff calculations, based on Bell and Muhidin 2009; Eurostat; U.S. Census Bureau; and State Statistics Committee of Ukraine.

lead to investments in locally appropriate enterprises. A mobile labor force can better adjust to shocks, and recover more quickly. Given the demographic outlook and the decline in the working-age population, increased labor mobility will be needed in Europe. And there is a lot of room for it.

Europeans are less mobile The European Union is the most integrated region in the world, and accordingly, migration between EU countries is higher than in other world regions. Europe’s aspiration, however, is more ambitious: a fully integrated labor market. Against this yardstick, Europe still falls short. By most measures, these differences are particularly great between the European Union and the United States (Ester and Krieger 2007, Eurofound 2006 and 2007, using Eurobarometer data 2005; figure 6.28). In the former EU15, prior to enlargement in 2004 and 2007, only about 1 percent of the working-age population changed its country of residence in a given year. By contrast, until recently about 3 percent of the working-age population in the United States moved to a different state in a given year. In Australia, this figure is 2 percent; in Canada, slightly less than 2 percent. Even in Russia, with its history of restrictions on peoples’ movement, mobility is 1.7 percent. With a common language and fewer institutional differences, people in Australia, Canada, and the United States can move with greater ease than Europeans. Measures of movement between territories (at the Nomenclature of Territorial Units for Statistics 2 level) within EU countries change the picture considerably: about 21 percent of the EU population has lived in a territory or country other than where they were born. But even by this measure, labor mobility is still below that of the United States, where 32 percent of the population lives outside the state they were born in.23 About 2 percent of the

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EU labor force was born in a member state different from their current state of residence; approximately 4 percent of the EU population have lived in another EU country at some point in their life; and 3 percent have lived in a country outside the European Union (Eurofound 2006). Internal mobility is difficult to compare across countries because its measurement depends on the size of the measurement unit. If the measurement unit is small—for example, the municipality—the corresponding internal migration rate will be high, because many more people move across municipalities than between provinces. Plotting the average size of the unit of measurement (like region or district) against the corresponding internal migration rate controls for the size of administrative units (figure 6.29). Applying a log trend, the exercise reveals that many European countries, especially the transition economies, have low labor mobility.

Table 6.2: Internationally, the Irish are the most mobile Europeans (percentage of population, by type of mobility) Local move

Move in country

Move inside the European Union

Ireland

44.5

18.8

14.5

Luxembourg

53.8

19.4

13.2

Cyprus

47.8

17.2

8.1

Denmark

62.6

36.2

7.5

Sweden

65.9

41.8

7.1

United Kingdoma

52.3

23.7

6.6

Finland

64.5

34.7

5.1

Germany

59.4

18.1

4.9

Belgium

59.6

13.0

4.5

Spain

46.6

9.9

4.5

Greece

34.7

16.4

4.4

Netherlands

55.0

21.6

4.4

Portugal

41.7

8.6

4.2

Austria

54.1

9.4

3.4

Malta

27.6

6.2

2.7

France

58.2

28.8

2.6

Latvia

44.2

22.5

2.0

Czech Republic

41.9

8.2

1.6

Italy

43.8

7.9

1.6

Slovenia

38.2

9.6

1.6

Slovak Republic

34.2

5.8

1.4

Estonia

50.5

23.4

1.1

Poland

40.6

7.1

1.0

Hungary

47.5

9.9

0.7

Latvia

57.4

7.4

0.7

a. Includes Northern Ireland. Note: The table shows weighted averages. Multiple answers allowed. Source: Bonin and others 2008.

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But lower labor mobility within a single market could reflect the smaller size of countries and shorter distances between centers of economic activity. Why move when you can commute? In a 2008 report on labor mobility in Europe, the Institute for the Study of Labor adopted a broad definition of geographic mobility that included not only changes of residency within countries and across borders but also cross-border and regional commuting (Bonin and others 2008, using the European Labor Force Survey). The report showed that ,even by the broader definition, between 2000 and 2005, workers’ mobility within the European Union was barely 1 percent each year and that the movement of people in Europe was still lower than mobility across Australian (2 percent) and U.S. (3 percent) states. The Institute for the Study of Labor report also showed that in the EU15, the share of the active working-age, foreign-born population from an EU27 country increased during the previous decade. Spain had the largest increase, followed by Greece, Denmark, Portugal, Sweden, Ireland, the United Kingdom, and Austria. Among the newer member states, those with the highest initial share of foreign-born people (Latvia and Estonia) showed a decline over time. In most EU15 countries, foreign nationals from another EU15 country comprise only a small share of foreign nationals. An exception can be found in the United Kingdom: the largest nonnative resident minority group in London is from France. These statistics present a paradox. The movement of people within the European Union is one of the Four Freedoms, and probably the one that comes most immediately to the average European’s mind when asked why the European Union is important. The Eurobarometer survey in 2005 showed that European citizens view geographical mobility positively (table 6.2). Yet, a large majority (almost 70 percent) had no intention of moving in the near future. This may be changing. The same survey showed that mobile Europeans are younger and have higher levels of education than those who have no intention of moving. In these respects, they are similar to mobile people in many countries, both wealthy and poor (Mansoor and Quillin 2006). Students in Europe are among the most mobile, enthusiastically taking advantage of such cross-border education programs as Erasmus. For many, these programs lead to longer-term resettlement Figure 6.30: Low labor mobility can keep unemployment high (labor mobility and unemployment rates in the nine largest OECD countries, 1980–95)

(labor mobility and unemployment rates in EU member states, 1995–2006)

Source: Hassler and others 2005.

Source: World Bank staff calculations, based on Bonin and others 2008; and Eurostat.

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GOLDEN GROWTH

for employment. Recent statistics show an increase in mobility. In 2008, about 2.3 percent of EU citizens (11.3 million people) resided in a member state other than their citizen state, according to the European Commission.24 That number has grown more than 40 percent since 2001. A lack of movement is often blamed for high unemployment rates in areas that lag and for labor shortages that drive up wages in places that lead. This negative correlation between mobility and unemployment is apparent in data from selected OECD countries for 1980 to 1995 (Hassler and others 2005; figure 6.30). Labor markets can respond differently to shocks, often resulting in differences in the impact on jobs across areas. Adjustment to regional shocks in Europe has been achieved more through unemployment rates and changes in labor force participation (people stop looking for work if a region goes into economic decay) and less through mobility of labor.25 By contrast, in the United States, labor mobility leads to greater agility in responding to differences in wages and job opportunities across states, reducing disparities in unemployment rates and real wages.

Table 6.3: Not a single market for new members (EU15 restrictions on workers from newer member states) Entry of workers from Bulgaria and Romaniaa

Entry of EU8 workers May 2004 to April 2006

May 2006 to April 2009

2007–08

Austria

Restricted

Restricted

Restricted

Belgium

Restricted

Restricted

Restricted

Denmark

Restricted

Restricted

Restricted

Finland

Restricted

Open

Open

France

Restricted

Restrictedb

Restrictedb

Germany

Restricted

Restricted

Restricted

Greece

Restricted

Open

Restricted

Ireland

Open

Open

Restricted

Italy

Restricted

Openc

Restrictedd

Luxembourg

Restricted

Restricted

Restricted

Netherlands

Restricted

Opene

Restricted

Portugal

Restricted

Open

Restricted

Spain

Restricted

Open

Restricted

Sweden

Open

Open

Open

United Kingdom

Open

Open

Restricted

a. Bulgarian and Romanian workers also face restrictions in Hungary and Malta. b. Except for health care, transport, construction, hotels, and catering. c. Since July 2006. d. Procedures for obtaining work permits are simplified in certain sectors. e. Since May 2007. Between May 2006 and April 2007, the Dutch labor market was open to EU8 workers in a large number of sectors. Source: OECD 2007.

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70

Figure 6.31: Greater labor mobility is associated with higher rates of employment in Europe (correlation between labor mobility rate [average 1996–2006, horizontal axis] and employment rate [average 1996–2006, vertical axis], selected European countries: coefficient 0.677)

Note: Labor mobility is the share of the population that moved from one region (Nomenclature of Units for Territorial Statistics level 2) to another within a given year. Source: World Bank staff calculations, based on Bonin and others 2008; and Eurostat.

But does a mobile labor force really make much of a difference for a country’s economic prospects? Policymakers are aware of statistics showing the relative immobility of Europeans and eager to know what they can do about it. The phased withdrawal of restrictions on the movement of people from the newest member states of the European Union will bring a gradual disappearance of an obvious obstacle. Yet people from the newer member states still face explicit barriers to mobility within the European Union (table 6.3).26 Lessons from how different EU15 members have managed this aspect of enlargement are still being absorbed, but evidence from movements since 2004 and in reaction to the crisis indicate that the member states that embraced newcomers from the newest member countries have benefited. Looking beyond adjustment to shocks and recovery from the recession, a growing literature provides evidence that internal labor mobility tends to have positive effects on countries’ productivity and growth. For example, without mobile labor, the growth rate of the United States would likely have been only half of what it actually has been (Rutkowski 2010). In Canada, the movement of people across provinces contributed to economic growth (Sharpe, Arsenault, and Ershov 2007). Due to the high volume of movement from low-productivity eastern provinces to high-productivity western provinces, Canada benefited from a huge boost to economic growth in 2006. Net output gains arising from interprovincial movement are estimated to be 0.074 percent of GDP in constant 1997 prices and 0.137 percent of GDP in current prices. Interprovincial movement accounted for 1.56 percent of trend labor productivity growth in Canada over 1987–2006 and 6.23 percent of actual labor productivity growth in 2006 (Sharpe, Arsenault, and Ershov 2007). Further, countries with higher labor mobility have better-performing labor markets and higher rates of employment. For instance, the three European countries that have reached the Lisbon employment targets—the Netherlands, Sweden, and the United Kingdom—all have labor mobility rates in the top quartile (figure 6.31). Conversely, countries with the highest dispersion in employment rates across their territories (Italy, Spain, Hungary, and the Slovak Republic) have mobility rates below the European average.27

325


GOLDEN GROWTH

Researchers have been trying to identify the impediments to mobility in economic areas where labor is legally free to move. Language and cultural barriers obviously play a role (OECD 2007). But putting language aside, even with a legal right to work in every member state, EU citizens face implicit but powerful deterrents created by differences in rules that determine social insurance coverage, the accrual of occupational pension rights, entitlements to social housing and other forms of assistance, and the recognition of their professional qualifications and previous work experience. Perhaps reflecting the current tough times, as in Europe, local chambers of commerce and professional guilds of U.S. trade associations are starting to erect barriers—even to people offering their services online—in order to restrict movement and thus competition. This strict “rule of license” is an obstacle to movement and faster labor market adjustment. These impediments may be more serious for prime-aged workers than for the young or the retired. As the median age of Europeans increases from 40 years today to nearly 50 by 2050, the mobility imperative will become more pressing.

What keeps Europeans at home Among the strongest deterrents to greater mobility in Europe are those created by failures in housing markets (figure 6.32). In many European countries, housing is a good that is still exchanged informally on unregulated or poorly regulated markets (Janiak and Wasmer 2008). Rental markets are shallow, rent is expensive, and supply is limited by zoning restrictions. These problems constrain people’s mobility at both their origin and destination: moving can be a costly prospect, made more so by difficulties selling or renting one’s house. Bottlenecks in the housing market are a serious impediment to mobility. Homeowners in Europe are more sluggish to move in response to changing labor market conditions than people who rent their homes (Hughes and McCormick 1985 and 1987; Henley 1998; Gardner, Pierre, and Oswald 2001). The relatively high unemployment rates in some European countries can be explained in part by a large portion of people who are owner-occupiers (Haavio

Figure 6.32: Language, housing, and health care are the main impediments to mobility (factors that deter people from moving to another EU country [percent])

Note: Figures are for respondents from the EU25 (EU27 excluding Bulgaria and Romania) who do not intend to move. Source: Karppinen, Fernandez, and Krieger 2006.

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and Kauppi 2003). The constraints to labor mobility created by failures in the housing market have been documented elsewhere (Mansoor and Quillin 2006) and create powerful deterrents to movement even in countries on the European Union’s doorstep (box 6.5). Another likely culprit preventing Europeans from moving is the relative rigidity of wages and generous pay-out period of unemployment insurance plans. Wage regulation leads to an earnings compression that can mute the signals that the labor market sends from one part of a country to another. If wages are not sufficiently flexible, they can fail to provide incentives for capital to flow into economically lagging regions or for workers to move to economically booming regions. Generous unemployment insurance plans that provide support over long periods can act as a disincentive for workers with industry-specific or placespecific skills to retrain and move. A negative relationship can be shown between the mobility rate and unemployment insurance: on average, high-mobility countries are characterized by low unemployment insurance benefits, while low-

Box 6.5: Labor mobility is low even in countries in the European neighborhood: the case of Ukraine Internal mobility in Ukraine is lower than in other countries. Between 2002 and 2009, an average of 1.5 percent of the Ukrainian population moved across rayons (districts), from rural to urban settlements, or between urban settlements. This corresponds to just over 600,000 of Ukraine’s 46 million people officially changing their place of residence during the year. During the economic crisis in 2009, internal migration rates actually fell compared with the average in previous years (from 1.5 percent to 1.3 percent when measured across settlements and from 0.6 percent to 0.5 percent when measured across

regions). As expected, mobility across regions is lower: the internal migration rate was 0.5 percent in 2009. When compared with that in other countries, Ukrainian internal mobility seems to be about 0.5 percentage points below its expected value. At the same time, labor market disparities in unemployment rates and average wages are high and persistent (box figure 1). This suggests that the Ukrainian population is not responding to economic opportunities outside their current place of residence. Instead, Ukrainians are moving to where there are

better services (such as schools and clinics) and infrastructure (such as housing)—the “push factors.” This could indicate that there are barriers to internal mobility that limit people’s ability to respond to economic incentives and to move to where higher returns to labor and human capital exist: for example, lack of affordable housing where jobs are, even after accounting for higher average earnings in these prosperous places. Cross-country evidence suggests that countries with higher labor mobility—notably the Nordic countries—also have lower spatial disparities in unemployment rates.

Box figure 1: Migration gap and dispersion of unemployment rates (average, minimum, and maximum across regions for various countries in various years)

Note: The migration gap measures the distance between the expected internal migration rates based on the actual migration rate. Most countries refer to 2007, except Italy (2005), Portugal (2001), and Ukraine (2009). Source: World Bank 2011d, based on Eurostat; and State Statistics Committee of Ukraine.

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GOLDEN GROWTH

mobility countries have the most generous unemployment insurance plans (Hassler and others 2005). Higher structural unemployment in many European countries also deters the movement of labor. Although differences in unemployment rates between the lagging and leading parts of a country should encourage movement, a high overall national unemployment rate will discourage people from taking the risk. Unemployed workers will probably not want to pay the cost of moving to more dynamic parts of their country if they would still face the high likelihood of not finding a job.28 The lack of portable social benefits—such as pensions, health care, and social assistance—might also constrain the mobility of labor between EU countries. EU legislation grants portability of such benefits at a level not found in any other region of the world. In principle, the most important benefits (for example, public pension and health benefits) are fully portable within the European Union and, to some extent, with countries outside the European Union. Nevertheless, important challenges remain.29 First, the administration of portability can be burdensome for intra-EU migrants. For example, old-age pensions are not paid as a single benefit, but by each pension insurance fund separately. The determination of separate pensions, taking into account contribution periods from different member states, is complex and opaque. Second, legislation on portability does not apply to occupational benefits, so moving might lead to considerable losses. Third, social assistance benefits are excluded from portability; the lack of a Europe-wide social safety net could also act as a barrier to intra-EU mobility. Finally, some EU policies may inadvertently be keeping Europeans immobile. The free flow of trade in goods and foreign direct investment across the single market might reduce the need for labor to move. Trade flows react more elastically than people, and capital is far more mobile. Trade in goods—particularly intermediate goods—along with capital transfers could make the movement of labor to other economic areas less important. This is a “good reason” for lower labor mobility in Europe, especially in the European Union. But other policies may not be so benign. European agriculture and cohesion policies and investments from regional and structural funds could be creating disincentives for mobility. Regional development policy instruments pour investment into economically lagging areas, sometimes with the stated objective of fostering job creation to retain young and qualified workers. Although the track record of these policies is mixed at best, to the extent that they deter movement of people at the margin, they obviate the need for European workers to move to where job opportunities are better and more durable.

Losing the global race for talent There is a looming labor force deficit in Europe’s immediate future, and it is unlikely to disappear even if more people work, work longer, and become more productive. The aging of the European labor force cannot be prevented, not even under the most favorable scenario. In its annual report to the European Parliament, the European Commission pointed out that the population of the European Union will rise to 521 million in 2035 but then fall to 506 million

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Figure 6.33: European countries host fewer immigrants than other OECD countries (percentage of the population that is foreign-born, various OECD member countries)

Source: OECD 2008.

by 2060. In 2010, there were 3.5 people of working age (20–64 years) for every person age 65 or older. In 2060, there will be half as many (European Commission 2011).

Europe will need immigrants The European Commission’s report shows that immigration from outside the single market and even from far beyond the European neighborhood countries will be the main driver of population change in the European Union. In 2009, net immigration to the European Union was 857,000 people, contributing to 63 percent of total population growth. At the start of 2003, the number of thirdcountry nationals in the EU25 was 16.2 million, or 3.6 percent of the population. But by 2010, 20.2 million non-EU27 citizens were living in the European Union (4 percent of the total population). The European Commission noted that foreign citizens living in the EU27 were significantly younger (median age of 34.4 years) than the population of EU27 nationals (median age of 41.5 years). For this reason, immigrants are likely to help close the demographic deficit and meet the quickly rising costs of population aging. People have been crossing seas, mountains, rivers, and political borders into, out of, and throughout Europe for centuries. During the first great period of globalization in the late nineteenth century, right up to the interwar period, Europe sent large waves of people to the Americas, Africa, and the Antipodes. Postwar immigration to Europe on a mass scale is a recent phenomenon, with roots in the guest-worker programs that became common in the late 1950s and early 1960s to help sustain the fast pace of Europe’s Golden Age (Maselnik 2010). Between 1950 and 1990, the resident foreign-born population in the EU15 grew more than fourfold, from 3.8 million (1.7 percent of the population) to 16 million (4.5 percent). Between 2005 and 2009, the resident foreign-born population increased on average by 1.6 to 2 million immigrants each year, and accounted for approximately 80 percent of the overall population growth. During this period, only 20 percent of the population increase in the EU27 could be attributed to natural growth (live births minus deaths). Ironically, the countries that lead the statistics of recorded live births are all also the largest immigrant destinations in the EU27: France, the Netherlands, Spain, and the United Kingdom.

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GOLDEN GROWTH

The conclusion that one could draw is that before 2030 the European Union will experience a decrease of young (and semiskilled) workers with secondary education (Koettl 2009). The question addressed in this section is whether current European immigration policies can accommodate these needs or whether the policies need to be changed. Table 6.4: The wealthier countries in Europe attract fewer high-skilled immigrants than countries in North America (immigrants with a tertiary diploma in selected OECD countries by country of origin, total and recent immigrants in thousands, circa 2000)

Current immigration policies in Europe and other OECD countries provide some answers. Of particular interest are the lessons drawn from the four “Traditional Immigration Countries”: Australia, Canada, New Zealand, and the United States (figure 6.33). To attract the right types of immigrants in the future, European policies will need to be more proactive in selecting immigrants and preferably will rest on strong, demand-driven mechanisms that respond quickly to shifting economic and labor market needs. If Europe does not adjust its policies, it risks labor shortages in the future.

Total Residence Origin

United States

United States

EU15

Other EU OECD

Australia

Canada

New Zealand

Other OECD

–972

–178

–9

–219

-6

–665

–301

241

443

44

71

21

95

1

18

–1

–50

–11

–2

–30

EU15

972

Other EU OECD

178

301

9

–241

–21

219

–443

–95

1

6

–44

–1

50

2

665

–71

–18

11

30

1

Other countries

5,763

3,275

139

458

1,261

72

444

Net OECD

2,048

–1,469

–614

314

350

–12

–618

Net total

7,811

1,807

–475

772

1,611

60

–174

EU15

Other EU OECD

Australia

Canada

New Zealand

Other OECD

–154

–23

–5

–63

–1

–188

–14

25

15

7

29

Australia Canada New Zealand Other OECD

–1

Less than five years of residence Destination

Origin

United States

United States EU15

154

Other EU OECD

23

14

Australia

5

–25

–1

Canada

63

–15

–5

2

New Zealand

1

5

0

4

–2

–12

–5

0

–7

1

–7

0

12

0

188

–29

-4

5

7

1

1,211

412

7

114

334

29

38

Net OECD

435

–215

–47

40

–37

–6

–169

Net total

1,646

351

–18

158

360

25

58

Other OECD Other countries

Source: OECD 2008.

330

–1


CHAPTER 6

Europe’s immigrants are mostly unskilled Relative to other popular OECD destination countries, EU countries mainly attract low-skilled immigrants—those with at most primary education—in stark contrast to the Traditional Immigration Countries, which attract much lower shares of primary-educated migrants and far higher shares of tertiary-educated migrants. Migration outcomes occur on many dimensions, just as migration policies take effect through a wide range of institutions. It can thus be helpful to distinguish immigrants by their motivation to migrate, their legal status, their duration of stay, and their education and skills. With regard to government policies, the framework of ananlysis will distinguish between policies with a direct effect on the size and composition of migrant flows and stocks, like immigration rules, and policies with indirect effects, like social policies, labor market policies, and integration policies. The limited data currently available on the educational attainment of immigrant populations suggest that the 49 percent of the EU25+ immigrant population originating from outside the EU25+ are primary-educated, while only 25 percent have secondary education, and 21 percent have tertiary education (table 6.4).

Box 6.6: Beyond the white cliffs: immigration to the United Kingdom The United Kingdom is a major destination for immigrants in Europe, especially the highly educated. Among European countries, the United Kingdom enjoyed the third-highest inflow of permanent immigrants, amounting to 347,000 people in 2008—the foreign-born accounted for 10.8 percent of the British population—and attracted the secondhighest number of permanent highly skilled immigrants seeking employment (box figure 1). The United Kingdom was one of the few countries that did not impose any restrictions on labor from the newest member states of the European Union and is one of the hotspots for international students, hosting on average 132,700 international students between 2003 and 2008. The strength of the United Kingdom’s policy

orientation toward immigration is that it favors people who want to come to work. The employment rate among immigrants was 80 percent, 5 percentage points above the OECD average. According to estimates by the British Treasury, immigrants grew the working-age population by 0.5 percent a year between 2001 and 2006 and GDP by around £6 billion in 2006. Due to a large volume of immigrants since 2004, and to mitigate a possible threat to social cohesion, the United Kingdom introduced a points-based system, focusing more on the quality of immigrants than the quantity. The new system consists of five tiers, tier 1 for highly skilled migrants, tier 2 for skilled workers required in certain sectors, tier 3 for low-skilled workers, tier 4 for

students, and tier 5 for tourists, athletes, and musicians. A special cap of 21,700 for 2011–12 non-EU work visas was introduced, limiting the number of economic immigrants per year. However, immigrants who are earning more than £150,000 were excluded from the cap. There have also been problems related to integration of immigrants. According to Huddleston and Niessen (2011), British immigration policies are less favorable toward integration, to some extent due to the fact that immigrants are excluded from some social benefits. But the strong points of the British immigration policy are: education, with a well-tailored living-in-diversity training, and anti-discrimination regulation. The weakest element is the difficulty in obtaining permanent residence and nationality.

Box figure 1: Immigrants in OECD countries and share of foreign-born with tertiary education, 2008 Source: OECD 2008; and OECD International Migration Database.

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GOLDEN GROWTH

By contrast, the Traditional Immigration Countries have much higher shares of tertiary-educated migrants. About 40 percent of immigrants to Australia, New Zealand, and the United States have a tertiary education. Accordingly, their shares of primary-educated migrants are fairly low (16–30 percent). The range for secondary-educated migrants is wider, from 12 percent in Canada to 35 percent in the United States. Looking only at immigrants originating from the Middle East and North Africa, the outcomes for Europe appear worse. Almost two-thirds of the 2.5 million migrants from the Middle East and North Africa residing in the European Union have only a primary education, while those with secondary or tertiary education each comprise 17 percent. Again, the Traditional Immigration Countries attract much higher shares of tertiary- and secondary-educated migrants from the same Middle East and North Africa countries. These statistics show the obvious importance of geographical distance in determining the composition of immigration flows. Europe attracts a high share of low-skilled migrants from the southern Mediterranean, just as the United States attracts a relatively higher share of low-skilled migrants from Central America. Of migrants from Central America in the United States, 46 percent

Box 6.7: The smarter North Americans? Immigration to Canada Canada has one of the highest percentages of immigrants among developed countries, with highly favorable policies toward immigrants’ integration. In 2008, Canada’s foreign-born labor force accounted for 21.2 percent of total employment. Moreover, one in five people living in Canada was foreign-born. Between 15 and 20 percent of foreign students remain in Canada and start working. According to MIPEX III, Canadian policies toward immigrants’ integration are very favorable, ranking third. This high ranking pays dividends in the form of immigrants with topnotch skills. Canada has the second-highest share of immigrants with tertiary education among all OECD countries (box figure 1). In

Box figure 1: Immigrants in OECD countries and share of foreign-born with tertiary education, 2008 Source: OECD 2008; and OECD International Migration Database.

332

drawing foreign talent, Canada relies on a well-managed selection process. With its scoring system of visa applications, Canada prioritizes certain features of the labor force that are crucial for the country’s development. Canada chooses whom to grant visas based on a system that ranks candidates according to their profile—having a job offer or tertiary education, for example, grants additional points. Highly skilled, talented immigrants without a job offer can be admitted to the country. The Canadian system is designed to treat all immigrants equally, regardless of ethnicity, race, religion, or nationality. Permanent immigrants have the same access-to-work

opportunities as Canadian citizens, including setting up a business. Immigration policy provides stable solutions for fostering family reunion. Another aspect of integration policy is universal access to education for all children, regardless of immigration status. Political participation is one of the few aspects of life from which permanent immigrants are excluded. To become a citizen, one must pass a citizenship test, which measures language abilities and basic knowledge about the country. According to MIPEX, Canada has one of the most professional citizenship tests from all countries included in the ranking


CHAPTER 6

have just a primary education, compared with 23 percent of the overall immigrant population of the United States. If, in addition, the host country relies mainly on family reunification as its immigration policy—as the European Union does—and does not apply proactive economic immigration programs—as in the United States—the share of primary-educated migrants originating from these countries is likely to remain high. Europe is losing the competition for highly skilled migrants to the Traditional Immigration Countries. The exception is perhaps the United Kingdom (box 6.6). Indeed, the European Union is losing some of its most skilled people to the United States. Currently, the United States hosts 1.7 million tertiary-educated migrants from the European Union, while the European Union hosts roughly 200,000 tertiary-educated U.S. emigrants—a net drain of 1.5 million people educated mostly at the expense of European taxpayers. Does this imply that the European Union should copy the Traditional Immigration Countries’ policies of large-scale permanent immigration programs and, in particular, systems like Canada’s, which seems to attract by far the highest share of tertiary-educated migrants (box 6.7)? Should the European Union imitate demand-driven temporary worker programs for specialized migrants like those in the United States, which seems to attract the highest share of secondary-educated migrants? Or is there a genuinely European guest-worker program that will help master future challenges of migration? It appears that countries in Europe will have to adopt some of the attributes of more successful immigration policies, both in and outside Europe.

Needed: a more self-interested immigration policy When assessing the effects of institutional arrangements on immigration, it is useful to distinguish between types of migration. First, one can distinguish migration according to the intended duration of stay: temporary, transitional, or permanent. Temporary and permanent immigration are straightforward concepts. Temporary migrants arrive in the host country with no intention to stay longterm, leaving after a short period of time once their work contract or assignment expires, their education or training has finished, or their business objective is accomplished. Permanent migrants, by contrast, arrive in the host country to settle indefinitely, with no intention to return to their home country. In reality, a large part of migrants fall somewhere in between, in the category of transitional migrants. These are migrants who arrive on temporary visas and work permits with no intention to stay permanently but eventually become long-term or permanent settlers. Many migrants who arrived in Europe through the guestworker programs of the 1960s in Austria, France, and Germany probably never imagined they would stay on. Yet, as they performed inherently permanent jobs they integrated into the labor market and developed nation-specific expertise. They evolved into permanent migrants, generally with the support of their employers and host governments. One might distinguish between immigrants by their main motivation for moving: humanitarian, family reunification, or economic migration. Family reunification should not be seen separately from good economic management of immigration, as it is essential for the integration of immigrants. If these rules are too generous,

333


GOLDEN GROWTH

though, family reunification programs can become the driving factor of a country’s immigration policy, as has been the case for years in some countries in Europe and even the United States. When family reunification becomes the main driver of immigration policy, it can bias the selection of immigrants. The same holds for humanitarian migration, based on the right to asylum and refugee status. Initiatives to legalize undocumented migrants are a part of many immigration policies, sometimes nearly replacing a proactive immigration policy with purely reactive regularization, as in Spain. European immigration policies will have to be geared toward Europe’s economic and labor market needs, and immigration policies that focus on demand-driven elements may be the best way to do so. Well-designed immigration programs for temporary and transitional migrants are the best models for the “New Immigration Countries” of Europe to select the right types of migrants for their economies. Demand-driven programs have the advantage of being flexible and reacting quickly to changes in the labor market. They require less research and government planning, putting the administrative burden on employers. The disadvantage is that they need more monitoring of compliance and enforcement efforts by the government. Static models—in particular, points systems for permanent immigration—are less flexible, requiring more capacity to determine labor market needs and ensure a consistent selection process. Successful demand-driven immigration programs for temporary migrants offer jobs of a truly temporary nature, like seasonal jobs in agriculture and tourism. In addition, certain jobs in sectors with a highly competitive goods market can be subcontracted to foreign companies through trade in services, opening the gates for a new type of temporary migration, through Mode 4 of the World Trade Organization’s General Agreement on Trade in Services. Well-designed immigration programs for transitional migrants help identify successful newcomers by granting migrants temporary access to the host country—with full or limited access to the labor market—and offering a clear option for permanent residency and work permission. Three main avenues of transitional migration exist: education-to-residency, business-to-residency, and work-toresidency. Governments’ capacities to assess labor market needs and plan responsive immigration and labor market policies are not limitless. Immigration policies are more likely to be effective if designed to require less government planning (Hopkins 2002). For example, Koettl (2009) finds that Europe will need both highly skilled and semiskilled migrants with secondary education. Yet, all projections— especially long-term forecasts—are uncertain. European economies might develop faster than anticipated toward a more knowledge-based economy, or the flow of highly skilled migrants to other countries might increase. Both scenarios would shift the demand toward tertiary-educated migrants. At the same time, the need for low-skilled service providers might shift demand toward primary-educated migrants, as suggested by the increasing numbers of undocumented migrants. Planned immigration programs—like well-designed points systems—require the government to assess labor shortages and adjust the selection process of immigrants accordingly, which require resources and time, without a guaranteed good outcome. For example, although Canada’s points system attracts the largest

334


CHAPTER 6

share of tertiary-educated migrants, many end up overqualified for their jobs (Reitz 2011). This suggests that somewhere in the Canadian immigration system, there is a mismatch of supply and demand. The program seems designed to select highly skilled migrants, but the Canadian labor market either does not recognize immigrants’ skills or it simply demands less-skilled immigrants. Too many overqualified immigrants can be as distorting as too many underqualified immigrants. Allowing employers more say in the process could help reduce these mismatches. Points systems can include demand-driven components by granting additional credit to migrants with a job offer, as the Australian system does. This is complemented by a special visa type granted to visitors interested in obtaining a job, making the Australian immigration system more responsive to shifting labor market needs. Nevertheless, the system puts the government in the driver’s seat, with all the associated responsibilities and administrative costs this role implies. The biggest risk of government-controlled selection criteria is that they might fall prey to lobbying efforts. Such efforts could come either from the employers or from native workers. Demand-driven programs, by contrast, are less likely to be influenced by lobbying efforts because they decentralize the decision process, putting the employer in control. If well-designed, they also put the administrative and cost burden on the employer. The U.K. Work Permits program, for example, can issue a visa and work permit within 24 hours of the employer’s request— assuming the employer provides adequate documentation. Similarly, the U.S. H1-B visa procedure is initiated and sponsored by the employer for a specific migrant, though the bureaucratic procedures and costs are far more burdensome for the employer. The drawback of employer-driven programs, however, is that they require regulations to prevent employers from abusing the system and to ensure that employers hire migrants only in sectors and skills segments with labor shortages. For this, a so-called “labor market test” is usually administered, requiring the employer to first post the job vacancy for native workers; only after sufficient time has passed with the post unfilled can the employer turn to migrant labor. Europe can learn from the strengths and weaknesses of the Traditional Immigration Countries’ immigration policies. There is no one good program that addresses all the challenges of a well-crafted immigration policy. Points programs, employer-based programs, and General Agreement on Trade in Services Mode 4 programs all have their merits, but they serve different objectives. The underlying principle of a good immigration policy is its ability to respond to changing labor market needs. In this sense, European immigration policy has to become more selfish. But what immigration policies alone can achieve is limited. If Europe wants to win the global race for talent, it will need to make working and living in Europe more attractive for the world’s brightest. This can mean paying higher premiums on skills, increasing rewards for risk-taking, and encouraging entrepreneurship.

The European work model—reworked The countries covered by this report—members of the European Union, the EFTA countries, the candidate countries, and the Eastern European partnership countries—will lose 50 million workers between now and 2060. Today, the

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GOLDEN GROWTH

European labor force—the employed and active job seekers—consists of 323 million people; in 50 years, it will be down to 273 million, a decrease of 15.3 percent. Over the next 20 years, the labor force will lose 15 million workers (5 percent). The largest reduction will happen during the 2030s, when the European labor force is expected to fall an additional 14 million people. The fall will be especially severe for the European Union and EFTA countries. Their labor force will decrease by almost 40 million people (18 percent) over the next 50 years. The other Eastern European countries will not fare much better, with an equally steep decline of 16 percent. The only exception is Turkey, where the labor force is projected to increase by 12 percent until 2060. The current trends should not be allowed to persist. Many Europeans— especially women, youth, elderly, and some minorities—do not work at all, and they should be encouraged to work. Many Europeans retire too early, and they should work longer. Some unemployed Europeans do not look hard enough for work, and they should be encouraged to look harder. Only with radical policy and behavioral changes could Europe counter the shrinking labor force. Yet, even under such optimistic scenario, Europe would not be able to prevent its labor force from aging. If participation rates in all countries were to converge to those in northern Europe, or the retirement age were to increase by 10 years across the board, the European labor force would actually increase by 2060 (by 5 percent and 2 percent, respectively). If the participation in the labor force of women were to converge to that of men, the labor force would still decrease, but only by 5 percent, as opposed to 15 percent in the baseline scenario. None of these scenarios counteracts, however, the loss of young workers due to continually decreasing younger-age cohorts. Increased migration will also have to be part of the solution. With revamped immigration policies that combine the altruism of a humanitarian stance with the self-interest of an economic approach, Europe can attract bright Africans, Americans, and Asians. This chapter is perhaps best concluded with simple (but uncomfortable) answers to the questions posed at the start. Is there a European work model? Yes. And it makes Europe less competitive. A central aspect is that European model gives disproportionate power to those with protected jobs—the “insiders”—through employment protection legislation. This approach would have become difficult to sustain even without the onset of rapid aging. With this aging, it is already unsustainable. Countries such as Austria, Denmark, and the Netherlands, which have kept unemployment low and labor force participation high during the last decade, have done so in some measure by reducing this protection. They have made jobs more contestable. In the context of demographic change, how can Europe achieve a stable, more productive labor force? Countering the decline of the European labor force through increasing participation rates is important but not sufficient. Such measures cannot prevent a substantial aging of the labor force. In addition to immigration, boosting productivity of the labor force through increased investments in human capital is necessary. This requires harnessing the full potential of existing workers by prioritizing investments in the skills that are most relevant for the labor market today, and those that will allow them to adjust to changing labor demands tomorrow. Interventions should focus on overcoming failures in information and quality assurance that lead many people

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CHAPTER 6

to make suboptimal skills investments (too few engineers, technicians, and competent managers). Are employment and social protection practices inhibiting labor participation and efficiency? Yes, by creating powerful insiders with well-protected jobs at the cost of marginalizing others. In the broadest terms, reforms will have to reduce job security while modernizing how income security is provided. In wealthier countries, reduced employment protection can be combined with relatively generous unemployment benefits and social assistance, as long as there are strong incentives and effective assistance programs to return the unemployed to work and to encourage the inactive to participate. Governments capable of administering programs that supplement employment protection legislation with well-designed income support and job search assistance should institute them. But to work well, this “flexicurity” requires high labor force participation rates that are many years away for many in Europe, as well as institutional maturity and fiscal and administrative resources that are out of reach for most. Especially in the east and south, there may be no alternative but to reconsider the extent of employment protection and the generosity of social protection. But all countries should synchronize social insurance for the unemployed with social assistance for the unlucky in order to align incentives for work, as Germany did between 2003 and 2005. Is Europe taking advantage of the greater potential for labor mobility due to economic integration? Undoubtedly, the European Union is the most integrated region in the world, and migration between EU countries is higher than in other world regions. Europe’s aspiration is, however, more ambitious: the aim is a fully integrated labor market with no borders. Against this yardstick, Europe still falls short. Significant challenges to improving labor mobility, even within European countries, remain. Mobility does come with social costs—missing the support of family and friends—that governments cannot easily reduce. But the costs related to education, housing, and health care can and should be reduced. These are some of the features that make the United States the most mobile economy in the world, and Europe can learn without losing its uniqueness. How can Europe attract the best and brightest? A million people emigrate to Europe every year, but less than one in five has more than a high school diploma—and three of five do not even have that. Attracting global talent would require looking closer at successful, demand-driven schemes from the Traditional Immigration Countries—Australia, Canada, New Zealand, and the United States. Immigration policies should focus less on political factors such as family reunification, asylum, and human rights and respond more to the demands of employers and longer-term assessments of skill shortages. Changes in immigration policies need to be combined with reforms aimed at making Europe a good place to innovate, start businesses, and reward risks. Similarly, increased immigration without more contestable jobs and reformed social safety nets could undermine the success of immigration reform. Over the last decade and a half, emerging Europe may have done better than advanced Europe in taking advantage of expanding opportunities for trade, finance, and enterprise. The prospects ahead are bleaker. Demographic shifts threaten Central and Eastern Europe just as much as most countries in Western Europe, which have been reforming labor market policies and can more easily

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GOLDEN GROWTH

become attractive destinations for immigrants. The exception is Southern Europe, which has not done well in recent years and is projected to shrink and age over the next decade. Greece, Italy, Portugal, and Spain illustrate most starkly how work is simultaneously the weakest part of the European economic model and one of its most attractive attributes. Changing how the labor market is regulated and replenished will be difficult for politicians, but it is none the less urgent. Nor is it hopeless: countries such as Denmark, Germany, Ireland, and Sweden have shown that the European work model’s characteristics can be changed while keeping its character distinctly European.

Answers to questions on page 291

European economies generally have more stringent employment protection and more generous social benefits than their peers in North America and East Asia. Increased participation can help stem the decline of the workforce, but more competition for jobs, greater mobility within Europe, and measures to attract global talent will still be necessary. Employment protection gives too much power to those with jobs while banishing others to the fringes of the labor market, and generous social benefits weaken the incentives to work. Migration among and within countries in Europe is still low, and even intra-EU migration falls short of the European Union’s aspiration of a fully integrated labor market. Europe needs an approach to global talent with policies that link immigration to labor markets, and a business climate that rewards skills and entrepreneurship. 338


CHAPTER 6

Chapter 6: Annexes Annex 6.1: Principal component analysis Principal component analysis is a way to identify patterns in data with high dimension, which is otherwise hard to simplify. It is a mathematical procedure that uses an orthogonal transformation to convert a set of observations of possibly correlated variables into a set of values of uncorrelated variables— called principal components. The main advantage of principal component analysis is that it can compress the data by reducing the number of dimensions, without much loss of information. For it to work properly, the main criterion is to subtract the mean from each data dimension. The weighting of indicators maximizes the variance of the components across countries. The following instruments are used for the protection component: active labor market program spending as percentage of GDP, social assistance spending as percentage of GDP, gross replacement rate of unemployment benefits, minimum paid annual leave days, and duration of unemployment benefits. For the labor market flexibility component, the following indicators were used: the employment protection legislation (EPL) index as developed by the OECD and applied by the Institute for the Study of Labor to other countries, the tax wedge ratio, union density, minimum wage as a percentage of value added per worker, and maximum time limit in months of fixed-term contracts. The instruments in the first group (protection) are unidirectional, where higher values indicate more protection. The instruments in the flexibility group are, however, not unidirectional. To make them unidirectional, and to make the higher value representative of higher flexibility, the negative of EPL and the tax wage ratio was used. This transformation does not lead to loss of information, because principal component analysis is sensitive to relative scaling but not to the linear transformation of vectors. So, countries with highly flexible labor markets (higher values) are those with low EPL, low union density, low tax wedge, low minimum wages, and high maximum duration of temporary contracts; countries with high protection (higher values) are those with higher spending on “active” employment assistance programs, social assistance benefits, high replacement rates of unemployment benefits, and long duration of unemployment benefits and annual leave. The value 0 represents the average position in terms of flexibility and protection across all countries in the sample.

Annex 6.2: Modeling procedure and results The regression exercise uses two-stage least squares estimation with instrumental variables. Standard panel estimation procedures (random or fixedeffects estimation) were not employed because of insufficient explanatory power of these models and/or not enough data (tables A6.1–A6.4). Data were mainly from the Organisation for Economic Co-operation and Development (OECD), with supplements from the Institute for the Study of Labor, the World Bank, and Eurostat for the explanatory variables, and the International Labour Organization and European Bank for Reconstruction and Development for dependent variables.

339


GOLDEN GROWTH

Three data samples are examined: · Sample 1: EU and OECD members in other regions (particularly North America and East Asia) Data come from the OECD and cover only OECD members. Time period is 2001–07.30 · Sample 2: The EU15 and new member states31 Data come from the OECD. Use of the larger sample from the Institute for the Study of Labor was not possible due to a lack of relevant data. Thus, the sample covers three new member states with data available only (the Czech Republic, Hungary, and Poland). Time period is 2001–07.32 · Sample 3: EU new member states and aspirants in the European neighborhood Data come from the Institute for the Study of Labor database and time period covers years 1999, 2003, and 2007.33 Nine new member states (data for Cyprus, Lithuania, and Malta were not available) are covered.34 The model examines the impact of institutional factors on four indicators of labor market performance (Eurostat methodology): unemployment rate (UR), long-term unemployment rate (LTUR), employment rate (ER), and activity rate (AR). In line with the previous research, the dependent variables are represented in logs. The regression equation has the following form:

lnXti = α + β1 EPLti + β2 MWti + β3 TUti + β4 TAXti + β5 ALMPti + + β6 UBRRti + β7 INFLti + β8 LEFTti + εti (1), where X takes the form of UR, LTUR, ER, and AR in consequent regressions. Explanatory variables are the following: employment protection legislation (EPL) is the second version of the OECD employment protection legislation index, covering a wide spectrum of employment protection policies. Minimum wage (MW) is a cluster variable constructed according to minimum wage level and its relative share on median wage in the economy. This variable was omitted in the analysis on Sample 3 due to unavailability of the data. The trade unions’ power is represented by the trade union density (TU).35 Tax system consequences are reflected by total tax wedge on labor (TAX).36 To reflect the influence of labor market policies (LMP), expenditure on active LMP as percentage of GDP per percentage point of unemployment (ALMP) and initial unemployment benefits replacement rate (UBRR) is included. Active labor market policies expenditure is instrumented.37 In the analysis on Sample 3, two other indices available from the Institute for the Study of Labor replaced the initial unemployment benefits replacement rate—the average unemployment benefit (UNBEN) and maximum duration of unemployment benefits (UNBENDUR)—to reflect the effects of passive labor market policy spending.38 The actual unemployment rate is used in the regressions, but labor market institutions affect the equilibrium unemployment. To reflect this, an additional variable was used in the model―the change in the annual rate of inflation (INFL; Nickell 1997). This variable captures the influence of economic cycles and may also be considered an indicator of macroeconomic policy stance. Finally, unemployment level might also be influenced by political preferences of governments and conflict of interest over the power resources (Korpi 1991). To account for these political factors, one more variable was added in the regression model―the government orientation with respect to the economic

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CHAPTER 6

policy. Variable LEFT is a dummy acquiring 1 for parties defined as communist, socialist, social-democratic, or left-wing, where greater orientation on social issues resulting in lower unemployment is expected.39 As economic policy takes time to influence labor market performance, the LEFT dummy is used with a one-year lag. The model analyzes the correlations between labor market performance and labor market institutions. Its deeper explanatory power is rather limited, due to the lack of data on more countries and other relevant variables that might affect the dependent variables.40 Moreover, only three new member states are covered in Sample 2. It is thus impossible to run a separate analysis for this group. Generally, only the differences in the role of institutions between the whole region and one particular subsample—and their implications for the other subsample—are examined, using a modified Chow test (see also Cazes and Nesporova 2003).41

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GOLDEN GROWTH

Table A6.1: Regression estimation results: activity rate OECD Total OECD

European Union

EU OECD

non-EU OECD

Total EU

Old EU

NMS EU+European Neighborhood NMS EU

ALMP

0.072

***

0.101

***

-0.017

0.091

***

0.117

***

-0.081

TAX

-0.004

***

-0.004

***

0.000

-0.004

***

-0.005

***

0.005

EPL

-0.029

***

0.016

0.033

**

0.092

MW

-0.006

TU

0.001

UBRR

0.003

-0.106

***

0.018

Total

**

-0.016

***

-0.014

***

-0.017

***

-0.019

***

-0.042

***

***

0.001

*

0.006

***

0.001

***

0.001

**

0.017

***

***

0.002

**

-0.003

***

0.002

***

0.001

*

0.002

*

NMS EU

-0.077

-0.036

0.003

-0.015

0.017

-0.019

-0.001

**

0.004

Neighborhood -1.257

**

0.011 0.060

***

-0.001

UNBEN

0.001

0.001

0.000

UNBENDUR

0.000

-0.004

0.011

0.001

0.005

INFL

-0.001

0.000

-0.003

LEFT

0.008

0.011

0.017

constant

4.257

4.490

R sq.

0.486

0.643

0.973

0.660

0.638

0.903

0.443

0.743

0.933

168

119

49

126

105

21

30

19

11

0.000

0.000

0.000

0.000

0.000

0.000

0.018

0.000

0.081

N Prob > F Chow test F p-value

***

4.215

***

0.5648

-0.001

-0.001

-0.005

**

0.007

0.000

-0.079

***

-0.065

***

-0.054

***

4.225

3.547

***

4.081

***

4.835

***

4.243

***

0.9999

**

0.002 -0.120

***

3.725

***

0.8413

***, **, and * denote significance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: Regression method is a pooled two-stage least squares procedure with instrumental variables on panel data; robust standard errors are used. ALMP = active labor market policies, TAX = total tax wedge on labor, EPL = employment protection legislation, MW = minimum wage, TU = trade union density, UBRR = unemployment benefits replacement rate, UNBEN = average unemployment benefit, UNBENDUR = maximum duration of unemployment benefits, INFL = change in annual rate of inflation, LIFT = leftward-leaning government. Source: Fialová 2011.

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Table A6.2: Regression estimation results: employment rate OECD Total OECD

European Union

EU OECD

non-EU OECD

ALMP

0.085

***

0.100

***

-0.061

TAX

-0.009

***

-0.008

***

-0.004

EPL

-0.057

***

-0.063

***

MW

-0.004

TU

0.001

***

0.001

UBRR

0.003

***

0.003

Total EU

Old EU

NMS EU+European Neighborhood NMS EU

0.078

***

0.070

***

-0.119

***

-0.009

***

-0.010

***

0.016

-0.071

***

-0.058

***

-0.066

***

0.122

-0.025

***

-0.009

*

-0.008

*

-0.086

***

***

0.006

***

0.001

***

0.001

***

0.027

***

***

-0.003

***

0.004

***

0.004

***

0.001

Total

NMS EU

Neighborhood

0.087

0.044

2.531

-0.003

-0.009

0.005

-0.069

-0.026

-0.373

0.000

0.009

UNBEN

0.005

0.001

UNBENDUR

-0.005

-0.009

**

-0.034

0.001

0.010

***

0.002

-0.005

***

***

0.002

-0.009

INFL

0.005

0.009

-0.008

**

0.006

0.002

-0.008

LEFT

0.009

0.017

0.026

**

0.009

0.015

-0.215

***

-0.100

**

-0.070

constant

4.201

4.408

***

4.192

2.796

***

4.179

***

4.254

R sq.

0.664

0.622

0.707

0.621

0.671

0.822

0.249

0.695

0.668

168

119

49

126

105

21

30

19

11

0.000

0.000

0.000

0.000

0.000

0.000

0.198

0.003

0.736

N Prob > F Chow test F p-value

***

4.171

***

0.5037

***

4.227

***

0.9999

0.117 ***

4.819

**

0.8499

***, **, and * denote significance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: See note for Table A6.1. Source: Fialová 2011.

343


GOLDEN GROWTH

Table A6.3: Regression estimation results: unemployment rate OECD Total OECD

European Union

EU OECD

non-EU OECD

Total EU

Old EU

NMS EU+European Neighborhood NMS EU

ALMP

-0.327

***

-0.314

***

0.624

-0.198

*

-0.118

TAX

0.021

***

0.013

***

0.016

0.018

***

0.026

***

-0.099

EPL

0.146

***

0.378

***

-0.166

0.350

***

0.383

***

-0.027

MW

0.010

-0.037

*

0.204

TU

-0.001

0.000

UBRR

-0.002

-0.009

***

-0.008 **

0.019

***

0.397

-1.249 ***

-0.008

0.325

**

-0.002

-0.002

-0.058

***

***

-0.015

***

UNBENDUR

LEFT

0.125

**

0.107

constant

0.982

***

1.274

R sq.

0.378

N Prob > F Chow test F p-value

-0.058

0.044

*

-0.040

*

-0.161

*

0.133

***

0.046

1.174

0.401

0.787

0.345

0.495

168

119

49

126

0.000

0.000

0.000

0.000

0.9838

**

Neighborhood

-0.444

-31.016

-0.021

-0.047

0.123

2.793

-0.029

**

-0.033

0.009 -0.024

-0.033

**

-0.007

UNBEN

INFL

NMS EU

0.020 0.538

-0.018

-0.012

Total

-0.010

0.103

0.029

0.039

0.128

-0.004

-0.051

*

-0.005

0.016

**

0.081

0.876

***

0.298

0.087

-1.463

***

0.808

5.724

***

0.785

3.218

-1.603

0.889

0.369

0.583

0.856

105

21

30

19

11

0.000

0.000

0.003

0.068

0.146

***

0.916

**

-0.011

0.6765

***, **, and * denote significance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: See note for Table A6.1. Source: Fialová 2011.

344


CHAPTER 6

Table A6.4: Regression estimation results: long-term unemployment rate OECD Total OECD ALMP

-0.639

TAX

0.097

EPL

0.185

MW

0.135

TU

-0.012

UBRR

-0.015

European Union

EU OECD

non-EU OECD

Total EU

1.802

-0.683

0.036

***

0.070

0.051

NMS EU

-9.916

-0.091

***

0.068

0.018

-1.513

-1.611

0.015

-0.103

UNBEN

-0.073

-0.007

UNBENDUR

0.119

0.181

0.086

-0.110

***

0.068

***

0.234

-1.354

*

0.179

0.139

0.068

-0.054

0.418

***

-0.004

0.033

0.235

**

-0.034

**

-0.016 ***

-0.636

Total *

**

**

NMS EU 0.779

***

-0.975

Old EU

NMS EU+European Neighborhood

*

-0.004

0.023

-0.022

0.004

-0.012

**

-0.021

**

-0.015

**

Neighborhood

-10.011 ***

**

0.012 Insufficient number of

INFL

-0.133

-0.210

LEFT

-0.177

-0.458

-0.957

constant

-2.466

0.392

R sq.

0.363

N Prob > F Chow test F p-value

-0.167

-0.352

0.015

-0.350

-0.413

0.864

***

0.684

0.420

-2.574

0.114

-0.513

3.827

**

4.223

6.899

0.281

0.681

0.279

0.285

0.915

0.763

0.853

168

119

49

126

105

21

18

17

0.000

0.000

0.000

0.000

0.000

0.000

0.180

0.067

***

0.9965

*

0.149 **

0.7392

**

observations

X

***, **, and * denote significance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: See note for Table A6.1. Source: Fialová 2011.

345


GOLDEN GROWTH

Notes

346

1

Alesina, Glaeser, and Sacerdote (2006) find no real correlation between the proportion of Protestants in a population and the average hours of work.

2

Alesina, Glaeser, and Sacerdote (2006) indicate that the impact of taxes on labor supply disappears when controlling for unionization or labor market regulation. In an analysis of 16 OECD countries, they find a fairly strong negative correlation between hours worked and the percentage of the labor force covered by collective bargaining agreements. Working hours in Europe ßmight also be influenced by the strong political power of unions over welfare states.

3

See, for example, Clark, Georgellis, and Sanfey (1998); Drago and Wooden (1992); Freeman (1978); Gordon and Denisi (1995); and Judge and others (2001).

4

However, “trust in the education system” is positively associated with work centrality, which may indicate strongly held beliefs that effort is fairly rewarded.

5

See Lisbon Council Presidency Conclusions at http://www.europarl.europa.eu/ aboutparliament/en/0044c3dd41/EU-factsheets.html;jsessionid=BD54698E30F3A038 BA1D36B3E4FCBB8E.node1

6

As a robustness check, this analysis was also carried out using clustering techniques, with similar results.

7

Only 2007 data are used because of restricted data availability, but also to avoid capturing increases in social spending that took place in most European countries in response to the 2008–10 crisis.

8

Countries that are “mixed”—low labor force participation and low unemployment rates or high labor force participation and high unemployment rates—are considered “inefficient.”

9

The Gini coefficient data are from the WDI and do not distinguish between equity in income and consumption. Inequality in outcomes goes far beyond labor markets, as social transfers are likely to play an important role here. One option would have been to look at inequality in wages or labor income more generally, but no such data are available for many countries, especially in emerging Europe.

10

This projection assumes that overall immigration and participation rates by sex and age group remain at current levels.

11

For a more detailed discussion on incentivizing formal work, see World Bank (2011a).

12

See Hanushek and Woessmann (2008) for a literature review of the empirical relationship between economic growth and school attainment.

13

See Carneiro and Heckman (2002) for U.S evidence, Brunello and Schlotter (2011) for Europe, and World Bank (2011b) for summary evidence in middle-income countries.

14

The OECD has initiated its Program for the International Assessment of Adult Competencies to measure cognitive skills in the working-age population (a complement to the Programme for International Student Assessment). The World Bank’s Skills toward Employment and Productivity initiative complements the Program for the International Assessment of Adult Competencies initiative by also measuring noncognitive skills. First results are expected by 2013.

15

See, for example, Bowles and Gintis (2000) for evidence of employer surveys from the United Kingdom and the United States, Blom and Saeki (2011) for a study for India, and World Bank (2011b) for evidence from Latin America.


CHAPTER 6

16

For an extensive treatment of the impact of labor unions on labor market outcomes in Europe, see Alesina, Glaeser, and Sacerdote (2006).

17

Following Fialová and Schneider (2009 and 2011), Fialová (2011) uses two-stage least squares regression estimation with instrumental variables on pooled data. Standard panel estimation procedures (random or fixed effects estimation) were not employed for insufficient explanatory power of these models and/or too few data. Data were mainly from OECD with some supplements from the Institute for the Study of Labor, International Labour Organization, and European Bank for Reconstruction and Development.

18

The data are from the OECD, for 2001–07. The sample covers Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Japan, the Republic of Korea, the Netherlands, Norway, New Zealand, Poland, Portugal, Spain, Sweden, the United Kingdom, and the United States. Of them, 17 are classified as EU OECD and 7 as non-EU OECD.

19

The sample covers Austria, Belgium, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, the Netherlands, Norway, Poland, Portugal, Spain, Sweden, and the United Kingdom. Of them, 15 are classified as old European Union and 3 as new member states of the European Union.

20

Data are from the Institute for the Study of Labor database, for 1999, 2003, and 2007. The sample covers Albania, Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, the Kyrgyz Republic, Latvia, Macedonia FYR, Moldova, Poland, Romania, the Slovak Republic, Slovenia, and Ukraine. Of them, 9 are classified as new member states of the European Union and 6 as European neighborhood.

21

The generosity of unemployment benefits seems to have the reverse effect in nonEuropean OECD countries.

29

For a detailed discussion on conceptual issues regarding portability of social benefits, see Holzmann and Koettl (2011).

22

Bertola and Ichino (1995) argue that the persistence of unemployment in Europe in the 1980s and 1990s was caused by a lack of labor mobility and by people remaining in lagging areas.

30

23

However, Ester and Krieger (2007) and Eurofound (2006 and 2007) present data that indicate a decrease in interstate mobility in the United States over 2000–05.

The sample covers Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Japan, the Republic of Korea, the Netherlands, Norway, New Zealand, Poland, Portugal, Spain, Sweden, the United Kingdom, and the United States. Of them, 17 are classified as EU OECD and 7 as non-EU OECD.

24

See European Commission (2010c). In 2008, 37 percent (11.3 million people) of nonnationals in EU27 countries were citizens of another member state. The number of nonnationals in EU27 has increased 42 percent since 2001 (for further details, see Eurostat Statistics in focus 94/2009).

31

For this analysis, the new member states group generally consists of countries acceding to the European Union in 2004 and 2007.

32

The sample covers Austria, Belgium, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, the Netherlands, Norway, Poland, Portugal, Spain, Sweden, and the United Kingdom. Of them, 15 are classified as old European Union and 3 as new member states of the European Union.

33

For some countries, only some of these years with data available were covered.

34

The sample covers Albania, Bulgaria, the Czech Republic, Estonia, Croatia, Hungary, the Kyrgyz Republic, Latvia, Macedonia FYR, Moldova, Poland, Romania, the Slovak Republic, Slovenia, and Ukraine. Of them, nine are classified as new member states of the European Union and six as European neighborhood.

35

Trade union density refers to the share of workers who were trade union members. However, even if the density is low in some countries, it is a common practice to extend trade union agreements to nonunionized workers, thus covering a large share of employees in the economy (France and Spain, for example). Thus, the real degree of collective bargaining coverage—the share of all salary earners whose wage is determined by a collective agreement in a legal extension of bargained wage rates to nonunionized workers—would be a preferred indicator; unfortunately, such data are not available for the examined period and country sample.

25

Tatsiramos (2009) makes reference to important work by Decressin and Fatás (1995) and Jimeno and Bentolila (1998) about European trends. For the United States, Tatsiramos quotes Blanchard and Katz (1992).

26

Restrictions on the freedom to work can be maintained for up to seven years after the entry of new member states into the European Union. The last restrictions were lifted on workers from the EU8 countries in May 2011. Restrictions will be lifted on workers from Bulgaria and Romania in December 2013.

27

Using Nomenclature of Units for Territorial Statistics 2 data from the European Commission’s data source Eurostat http://ec.europa.eu/eurostat/ramon/ nomenclatures/index.cfm?TargetUrl=LST_ CLS_DLD&StrNom=NUTS_33&StrLangua geCode=EN

28

See, for instance, Bentolila (1997) for Spain; Pissarides and Wadsworth (1989) for the United Kingdom; and Fidrmuc (2004) for transition economies.

347


GOLDEN GROWTH

36

348

Total tax wedge on labor represents the combined central and subcentral government income tax plus employee and employer social security contribution taxes, as a percentage of labor costs, defined as gross wage earnings plus employer social security contributions; the tax wedge includes cash transfers. The indicator is calculated for a single individual without children, earning the average wage.

37

This variable is endogenous because it relates the expenditure to the actual rate of unemployment. For this reason, this variable was instrumented by a new variable relating the expenditure to the average unemployment rate in a five-year period before the actual year.

38

Average unemployment benefit is the average benefit as a percentage of the average wage. This definition deviates from the estimates typically used by the OECD because OECD replacement rates are not very meaningful in the transition countries due to the caps on the size of the benefit in many countries. Maximum duration of unemployment benefits is defined as the period for which a 40-year-old person who has been employed for 22 years prior to unemployment receives unemployment benefits, wherever possible. Data are from the Institute for the Study of Labor.

39

Data are from the World Bank’s database of political institutions; for details, see Beck and others (2001) and Keefer and Stasavage (2003).

40 These are, for example, the role of product market reforms (Boeri 2005; Griffith, Harrison, and Macartney 2007) or the importance of adverse economic shocks (Blanchard and Wolfers 2000).

41

A modified version of the test hypothesis and statistics was used, because the number of observations in the new member states group is smaller than the number of parameters, nNMS < k, and thus the standard methods in this case cannot be used. The hypothesis tested is H0 :E ( y | X; βOE) = E ( y | X; βNMS).


CHAPTER 6

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Chapter 7 Government To make sense of the relationship between government and well-being in Europe, Sweden might be a good place to start. The quintessential European welfare state, Sweden does well in social outcomes: children and students enjoy free education, the elderly receive a decent pension, everyone relies on a public health system that helps them live long and healthy lives, and social trust is high. The welfare system redistributes wealth and contributes to an equitable distribution of income. All this is done with big government. From 1980 to 2010, Sweden’s government spending accounted on average for 59 percent of GDP. These three-fifths of economic output that are spent by government are funded mainly by levying charges and taxes on workers, families, and enterprises. Such high taxation surely gets in the way of growth. Or does it? Over the last three decades, Sweden’s per capita growth was 1.7 percent—as it happens, just about the same as that of the United States. Yet government spending in the U.S. was only 37 percent, or about threefifths of government spending in Sweden. So what exactly allows Sweden to combine a sizable government, enviable social outcomes, and solid growth? After all, the economic literature on the size of government and the rate of growth tends to find that big government generally lowers growth. Is Sweden the exception from the rule, or are many European countries able to square the circle? And for those that don’t, what would it take to become like Sweden? Clearly, there are big governments in Europe that fail to deliver impressive results. Observers could point to Italy and Greece in Western Europe, or to Hungary and Ukraine in emerging Europe.

Are governments in Europe bigger than elsewhere? Is big government a drag on growth in Europe? If big government impedes growth, how do countries such as Sweden do so well? How can governments be made more efficient? Should fiscal consolidation be a top policy priority in Europe? 353


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Take Ukraine. Over the last decade and a half, Ukraine’s economy expanded at an annual average rate of 2.3 percent per capita. While this might be faster than Sweden or the United States, it is unimpressive relative to its peers: other nonEU Eastern European countries grew almost 3 percentage points faster. At about 41 percent of GDP the size of government was more than 6 percentage points higher in Ukraine than among its peers. And in 2010 government spending was almost half the size of the economy (49 percent of GDP), as public pensions absorbed 18 percent of GDP, among the highest in the world. In addition to large and ineffective public spending, Ukraine faces dim prospects: the growth drivers of the precrisis period up to 2008, such as capital inflows and credit expansion, along with favorable terms of trade adjustments, are unlikely to return. And fiscal pressures are set to increase with a rapidly aging population and large investment needs (World Bank 2010). This chapter links government and well-being in Europe in five steps. It first looks at whether governments are big spenders and how this affects growth. It next argues that there is more to government than just its size—namely, its quality—so it looks at how the size of government interacts with the quality of government. It then asks how well governments spend money on health, education, and pensions. Last, looking at pressures on public finances, it asks what governments can do to put their fiscal house in order. In other words, the chapter answers five questions: First, are governments in Europe bigger than elsewhere? Yes. Governments in Europe spend about 10 percent of GDP more than their peers. Differences in government size within Europe and between Europe and its peers are largely explained by social spending. In 2010, countries in Western Europe spent 9 percent of GDP more on social transfers and 13 percent of GDP more on overall public spending than four “Anglo-Saxon” countries (Australia, Canada, New Zealand, and the United States) and Japan. In the 2000s, Western Europe spent about 6 percent of GDP more on the social sectors than Eastern Europe, and had bigger governments by about 7 percent of GDP. Countries differ in the way they tax social benefits, however, so when allowing for taxation, the difference in social spending between Western European and Anglo-Saxon countries declines from 11 percent to 6 percent of GDP, and the south is the biggest social spender in Western Europe. Second, is big government a drag on growth in Europe? A qualified yes. Over the last 15 years, higher initial government size has led to slower economic growth. In Europe, a 10 percentage point increase in initial government size leads to a reduction in annual growth by 0.6–0.9 percentage points. Government reduces growth, particularly when it exceeds 40 percent of GDP. Perhaps because governments are smaller outside Europe, there is no evidence that government size generally harms growth in the global sample. In Europe, social transfers tend to reduce growth, and public investments to increase it. Large government revenues tend to reduce growth, but the evidence is less compelling than for public expenditures—perhaps because Western Europe’s tax system is often more growth-friendly than the systems of the four AngloSaxon countries. Europe combines a high tax burden and labor taxes with low corporate tax rates and a greater reliance on indirect taxes.

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Third, if big government impedes growth, how do countries like Sweden do so well? The reason is that size is not the only feature of government that matters. What government does and how it finances its activities are as important. European governments regulate the largest economic area in the world; encourage the exchange of goods, services, and capital with other continents; foster voice and accountability; and provide public goods and enable redistribution. Big governments are often good at doing these things, especially when social trust ensures that everybody plays by the same rules. Such big governments can go together with thriving, dynamic economies. Fourth, how can governments be made more efficient? Investigating the efficiency of the public sector is difficult because government output is hard to measure. But many studies identify vast “efficiency reserves” in the public sector: there is considerable scope for saving by moderating public wages and pensions, enforcing private contracts, and other means. The potential for increasing efficiency—getting more for public spending—differs across sectors. European governments are not big spenders in health or education, especially when considering that private spending in these sectors is less than in AngloSaxon countries. For health, public spending does well in reducing maternal mortality rates. For education, public spending does less well in raising net secondary enrollment rates. Case studies for Armenia, Moldova, and Poland point to three sources of inefficiencies: the inability to adjust spending patterns to shifting demographic trends, the weak incentives for local cost savings, and attempts to improve equity without proper evaluation of policy outcomes. While public spending on health and education does not stand out as excessive, Europe does spend more than peer countries on public pensions. Indeed, pension spending is the main reason for big governments in Europe—thanks not just to an older population but also to the generosity of pensions. Many countries have initiated reforms of the pension systems since the 1990s. Fifth, should fiscal consolidation be a top policy priority in Europe? Yes. Fiscal pressures are high for five reasons. First, fiscal deficits and public debt increased sharply during the recent global crisis, accentuating structural weaknesses in public finances. Second, because of the crisis, markets now pay more attention to fiscal vulnerabilities. Third, growth will be weaker now than before the crisis. Fourth, rapid aging will add to fiscal pressures over coming decades. Finally, public debt has to be reduced to put fiscal policy on a stable footing before the next crisis. Simulations suggest Western Europe has to improve its primary balance (the difference between revenues and expenditure, not including interest on debt) after adjusting for the business cycle by about 6 percent of GDP this decade to reduce public debt to 60 percent of GDP by 2030. Adjustment needs are highest in the south and lowest in the north. In the EU’s new member states, a fiscal adjustment of about 4 percent of GDP is needed to bring down public debt to 40 percent of GDP.

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Europe’s governments are big How big are governments in Europe exactly, and how did they change in the period before the global economic and financial crisis? Before starting to answer, it is necessary to clarify some data issues. Mainly, it is necessary to decide how to measure government size. Usually, it is best to use public expenditures as a percentage of GDP. Other useful indicators include the tax burden, public employment, or the number of pages of government-drafted regulation. The advantage of government spending is that it focuses attention on the uses of the public money raised from taxpayers and other sources. The mid-1990s are taken as the starting point. This might seem an odd choice, as national governments have been around a lot longer, and government size grew strongly in Europe after the early 1960s. Still, 1995 is a natural reference point for Europe as a whole. While longer time series are available for EU15 and OECD countries, reliable national accounts data and public finance statistics are hard to come by for countries from Eastern Europe before that year (box 7.1).

Governments are big, even in Eastern Europe European governments are big. In 2010, government spending accounted for over half of GDP in Western Europe, and over two-fifths in Eastern Europe. Figures 7.1 and 7.2 illustrate three patterns. First, European governments are bigger than non-European governments. In 2010, median government size was larger by 11 percent of GDP in Western Europe, and 13 percent of GDP in Eastern Europe, than among their respective peers. Second, government size is highest in the north, and lowest in eastern partnership countries. In 2007, on the eve of the global crisis, median public expenditure amounted to 47 percent of GDP in the north and 35 percent of GDP in the eastern partnership countries. Public expenditures ranged from over 50 percent of GDP in France, Sweden, and Denmark to around 35 percent in Estonia, Latvia, Lithuania, Romania, the Slovak Republic, and Turkey, and to less than 30 percent in Albania, Armenia, Azerbaijan, and Georgia. Government size in the peer countries was less than 40 percent of GDP. Third, the crisis increased government spending in 2007–10 in Europe and elsewhere, offsetting reductions in government spending in 1995–2007 in the north, the center, and the EU12 (figure 7.2).

Box 7.1: Data and groupings The sample in this chapter covers European and other countries with a population of at least 250,000 in 1995. This gives 167 countries, comprising 6 billion people in 2010, though most variables are available only for fewer countries. The data include 43 countries from Europe that are the focus of this report. In most cases, the unit of analysis is the country. We give the same weight to Germany, Europe’s most heavily populated country with a population of 82 million, and Iceland, the smallest with a population of 300,000.

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In addition, countries are grouped based mainly on geography to capture broad trends. In Europe, the west (EU15 and European Free Trade Association) is distinguished from the east (EU12, EU candidate, and eastern partnership countries). This results in 18 Western European countries and 25 Eastern European countries. In Western Europe, we distinguish between the north (Denmark, Finland, Iceland, Norway, and Sweden), the center (Austria, Belgium, France, Germany, Ireland, Luxembourg, the Netherlands,

Switzerland, and the United Kingdom), and the south (Greece, Italy, Portugal, and Spain). To benchmark Western Europe against the rest of the world, Anglo-Saxon peers (Australia, Canada, New Zealand, and the United States) and Japan are studied. For emerging Europe, the peers are Brazil, the Republic of Korea, and the Russian Federation, along with other emerging economies. Finally, to make sure that group averages are not driven by outliers or missing data, the median is used more than the mean.


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Figure 7.1: Government size in G7 countries, 1960, 1990, 2000, and 2010

Figure 7.2: Government size, 1995, 2007, and 2010

(government spending, percentage of GDP)

(median government spending, percentage of GDP)

Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on Eurostat; IMF WEO; and OECD National Accounts Statistics.

Figure 7.3: Density of government size in Europe

Figure 7.4: Government size in 1995 and 2010

Source: World Bank staff calculations, based on Eurostat; IMF WEO; and OECD National Accounts Statistics.

The impact of the crisis on government spending is visible in figure 7.3, which shows a kernel density plot of government spending in Europe for 1995, 2007, and 2010. In 1995–2007, the density became more concentrated, as the variation in government size declined. In 2007–10, the distribution shifted to the right, indicating higher spending induced by the crisis across Europe. Seven European countries spent more than 52 percent of GDP in 2010, versus only one in 2007. Government spending increased during the crisis relative to output mainly for two reasons: governments stepped up social spending to mitigate the social impact of the crisis and stabilize the economy; and the collapse in output meant that government size rose, even with no change in public expenditures. Still, there is a fair amount of persistence in government size across countries (figure 7.4).

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Figure 7.5: Social spending determines the size of governments (social transfers and overall government spending, percentage of GDP, 1970–2008)

Source: World Bank staff calculations, based on Eurostat; IMF WEO; and OECD National Accounts Statistics.

Social spending makes for big government Breaking down spending into its components provides better insight into what makes governments bigger in Europe. It makes sense to focus on social spending, as this turns out to drive much of the difference in overall government spending. It makes sense to start with social transfers; after all, the European welfare state is closely tied to large social transfer programs. Social transfers come in various types. They range from basic social assistance for poor families, to family benefits and child allowances, and to social insurance programs for old age, unemployment, disability, sickness, and maternity. They are mostly made in cash but some are in kind, such as some health or housing services. Looking at social transfers allows us to trace spending patterns for seven OECD countries since 1970 and for 14 OECD countries since 1980. We also have data for Eastern Europe for the 2000s. We will also look at social spending more broadly for the 2000s for Europe as a whole. Starting in 1970 is useful, much of the government expansion happened before the 1990s. Overall government spending moves in step with social transfers (figure 7.5). Increases in social transfers tend to increase government size, as in Australia (to the early 1990s), Belgium (to the mid-1980s), Canada (to the early 1990s), Germany (to the late 1990s, tied to reunification), the United Kingdom (to the late 1980s), the Netherlands (to the late 1970s), and the United States (to the early 1990s). Likewise, decreases in social transfers tend to reduce government size, as in Canada and the Netherlands (both from the early 1990s). Of course, the link is not perfect, as expenditure trends on other items often follow a different dynamic. The reduction in government size in Belgium since the mid-1980s, for example, did little to reduce social transfers. Instead, while maintaining social security spending constant, it relied mostly on lower federal spending and reductions in interest payments thanks to fiscal surpluses and declining public debt (IMF 2011). Nevertheless, there is a high correlation between government spending and social transfers in the OECD country sample. A simple regression of government spending on social transfers, including country and year dummies, suggests that an increase in social transfers by 1 percentage point of GDP leads to an increase in overall government spending by somewhat more than 1 percentage point of GDP.

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Figure 7.6: Social transfers increased fastest in the south (social transfers, 1980, 1990, 2000 and 2008, percentage of GDP)

Source: World Bank staff calculations, based on Eurostat; IMF WEO; and OECD National Accounts Statistics.

Figure 7.6 groups 14 countries in the usual fashion: Western Europe is represented by Denmark and Finland (north); Austria, Belgium, France, Germany, the Netherlands, and the United Kingdom (center); and Italy and Portugal (south). The peer countries are Australia, Canada, and the United States (Anglo-Saxon), and Japan. Three features stand out. · Social transfers in Europe are much higher than elsewhere. Median spending on social transfers in 1980–2008 was 20 percent of GDP for Western Europe, but only 11 percent for its peers. Median government size was 50 percent of GDP and 37 percent of GDP, respectively, for the two groups. Hence, higher social transfers accounted for about two-thirds—that is, 9 percent of GDP out of 13 percent of GDP—of the difference in government size. · Spending on social transfers moved up for Western Europe and the peers in 1980–2008, though slightly less so for Western Europe. These increases resulted in bigger governments for both groups—again, slightly less so for Western Europe. · Differences within groups emerge. In Western Europe, social transfer spending in 1980 was highest in the center, followed by the north, and lowest in the south. The entitlement reforms of northern countries and a strong economy lowered real growth of per capita social transfers in the 2000s, so that social transfers fell as a share of GDP. By contrast, social transfer spending rose sharply in the south, reaching 20 percent of GDP in 2008 compared with only 17 percent of GDP in the north. Social transfer spending also jumped in Japan. Its share in overall government spending rose from 30 percent in 1980 to 50 percent in 2008, mainly because of population aging. Social transfers are not all of social spending. They do not include salaries paid to public employees in social sectors, nor do they include education. Figure 7.7 uses a “functional classification” that provides another way to assess social spending. It shows public spending on pensions, health, and education for European countries in 2000 and 2007. Spending on the three social sectors tends to be higher than that on social transfers, though the latter does not include social assistance. Again, social spending is instrumental in determining

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Figure 7.7: Social spending increased in the 2000s (social and other government spending, percentage of GDP, 2000 and 2007)

Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on Eurostat; IMF WEO; OECD National Accounts Statistics; and WDI.

the size and change in overall government spending (Handler and others 2005). In particular, government size in Western Europe is about 7 percent of GDP larger than in Eastern Europe, and social spending accounts for much of the difference (6 percent of GDP). Western Europe spends around 23 percent of GDP on these sectors, Eastern Europe around 17 percent. The south stands out among the economies of high-income Europe, in that social protection and total spending increased after the 1980s, and showed no signs of slowing until the recent crisis. Social protection is more than pensions, and includes unemployment benefits, active labor market policies, child and maternity support, and welfare. The north stands out through high spending on social protection unrelated to pensions. In 2007–08, pensions were just over half of social protection spending in the north, compared with over three-fifths in the center and the EU12, about two-thirds in Japan, and close to three-quarters in the south. Anglo-Saxon countries also used about half their social protection spending on public pensions, but social protection spending remained low at less than 10 percent of GDP. Across the three social sectors, the north spent the most and the EU12 countries the least. The Anglo-Saxon countries spent less than Western Europe, the EU12, or Japan as a share of GDP on social sectors. Social transfers and services—summing pensions, health, and education—as a share of GDP in 2008 relative to per capita income adjusted for purchasingpower shows that social spending increases with income. This is what leads to higher spending in Western than in Eastern Europe. But for a given income, big differences across countries are seen. For example, Germany spent almost 25 percent of its income on social transfers, and Iceland just 6 percent. Ukraine’s spending is the highest in Eastern Europe for both social transfers and social sectors, though many countries are notably richer. Looking at gross public spending in social sectors to assess what governments invest in education, health, and social protection is instructive, but potentially

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misleading. Countries differ in the extent to which they tax social benefits. Net public expenditures take into account whether governments tax social benefits or provide tax breaks for social purposes. They are a more accurate measure of the fiscal resources benefiting the social sectors. The OECD provides comparable numbers on gross public expenditures and net publicly mandated social expenditures for 26 member countries for 2001 and 2007 (Adema and Ladaique 2009). The tax impact is strong for three main reasons. The social sectors are smaller than suggested by gross public expenditures in Europe. In 2007, taking Western Europe as one group, social spending declines from 34 percent to 29 percent of GDP. And while the center, the EU12, and the north tax many of their social benefits, most of them remain untaxed in the south, giving it Europe’s largest social sector net of taxes. Finally, while taxation reduces social sectors in Europe, it leaves them unchanged (or even slightly increased due to tax breaks for social purposes) elsewhere. The gap between Western Europe and Anglo-Saxon countries, for example, declines from 11 percent to 6 percent of GDP.

Political institutions reveal preferences for big or small government While government size changes over time, governments are systematically bigger in some countries than others. So what can we say about economic, social, and political factors that lead to big government? Lindert (2004) has conducted perhaps the most careful analysis for Europe, and found that the rise in the welfare state and the expansion of social transfer programs over the last two centuries is linked to five factors: democracy, social affinity, aging, prosperity, and globalization.1 Democracy gives people an equal vote, irrespective of income. Combined with social affinity across income groups, it makes the decisive median voter more likely to support redistributive tax-based programs. Because older people prefer social insurance and are a key voting group, social transfers increase as the population ages. Social transfers emerged with prosperity. They came about for the first time in 1880–1930 when living standards improved in Europe, reflecting the widening impact of the industrial revolution. Finally, voters might demand protection for those hurt from international competition in open economies. The political variables deserve closer attention. Economic policies have distributional consequences, as they often create “winners” and “losers” in society. Political institutions such as electoral rules are important for policy outcomes because they determine how competing preferences are turned into public policies. In Europe, political structures differ among groups. Northern countries, for example, have political systems that are based on proportional representation and on coalitions rather than single-party governments, that are more centralized, and that have single legislative chambers and relatively weak presidential power. But do political institutions matter once we control for economic and social characteristics? For 67 European and peer countries in 1995–2009 it appears that, as expected, government size is influenced by preferences for public

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services and social affinity, the age dependency ratio, unemployment, income per capita, trade openness, and the debt servicing costs of public debt.2 Consistent with the literature, political variables are important: government is bigger in countries with fractionalized (for example, coalition), proportional, and parliamentary political systems. Federalism also increases government size, which suggests cooperation of central and local governments rather than competition among governments. Even when the full set of economic, social, and political factors are controlled for, geographic regularities remain: northern Europe has the biggest governments, the emerging peers the smallest (table A7.1).

Big government, slow growth? GDP per capita is the best single measure at hand to proxy a country’s living standards. Yet it has faults, including how to factor the government sector in production of domestic value added, how to incorporate quality improvements in provision of services, and how to account for depletion of national resources. Still, it is important to know whether big government helps or hinders growth, and even if well-being and happiness go beyond purely money-oriented notions, being rich and growing richer make it easier to get the things we want, such as food, education, health care, and time off from work. There are good reasons to suspect that big government is bad for growth. Taxation is perhaps the most obvious (Bergh and Henrekson 2010). Governments have to tax the private sector in order to spend, but taxes distort the allocation of resources in the economy. Producers and consumers change their behavior to reduce their tax payments. Hence certain activities that would have taken place without taxes, do not. Workers may work fewer hours, moderate their career plans, or show less interest in acquiring new skills. Enterprises may scale down production, reduce investments, or turn down opportunities to innovate. High taxes make market work less attractive, and time off from work and work at home more attractive. Thus high-income taxes inhibit the development of markets that offer home-produced services. Such service sector jobs could be important to keep workers in jobs and off the welfare system, especially as traditional manufacturing jobs dwindle (Davis and Henrekson 2005). Over time, big governments can also create sclerotic bureaucracies that crowd out private sector employment and lead to a dependency on public transfers and public wages. The larger the group of people reliant on public wages or benefits, the stronger the political demand for public programs and the higher the excess burden of taxes. Slowing the economy, such a trend could increase the share of the population relying on government transfers, leading to a vicious cycle (Alesina and Wacziarg 1998). Large public administrations can also give rise to organized interest groups keener on exploiting their powers for their own benefit rather than facilitating a prosperous private sector (Olson 1982).

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Box 7.2: Transaction costs and government bureaucracies What accounts for government getting bigger even though it means taxes and red tape?

hire workers daily with on-the-spot contracts for many interrelated tasks.

Mulling over the nature of firms, Coase (1937) and Williamson (1985) suggest that transaction costs prevent companies from using market price signals to coordinate their everyday work. Complex production processes lead companies to enter into long-term contracts with employees as it would be too costly to

Olson (1986), using transaction cost theory, sees a similar rationale for government. The public sector facilitates economic arrangements by keeping transaction costs low. Public bureaucracies produce large indivisibles, such as defense, police, justice, and other public goods. They are crucial

for enabling businesses to hire and dismiss workers, sign contracts with suppliers and banks, or, in general, engage in buying and selling of goods and services at low cost. In short, transaction costs make public—and private—bureaucracies inevitable, even though they also generate inefficiencies. Of course, governments might fail just as markets fail, but market failures justify government intervention in the first place.

Yet, although taxes change market outcomes, they are also necessary. Without them, governments cannot fulfill the core functions vital for market economies (box 7.2). Indeed, governments around the world contribute to economic prosperity by financing, providing, or regulating services. Some services are replete with market failures, whether due to monopoly power, externalities, or information problems. Such concerns provide a justification for the welfare state (Barr 1992; Besley and Persson 2001). Of course, public social spending is often not so much about responding to market failure as it is about ensuring that basic needs are met and social inequities do not violate society’s values regarding fairness. What’s the upshot of this discussion? Although voters have to judge whether the benefits of public spending outweigh the costs of taxation, economic theory is ambiguous on the impact of government size on growth. But economic models argue that the excess burden of tax increases disproportionately with the tax rate—in fact, roughly proportional to its tax rate squared (Auerbach 1985). Likewise, the scope for self-interested bureaucracies becomes larger as the government channels more resources. At the same time, the core functions of government, such as enforcing property rights, rule of law and economic openness, can be accomplished by small governments. All this suggests that as government gets bigger, it becomes more likely that the negative impact of government might dominate its positive impact. Ultimately, this issue has to be settled empirically. So what do the data say?

Europe is different At first glance, the relationship between government size and growth is not clear-cut. In 1995–2010, median growth was higher in Western Europe than in its peers, but its governments were also bigger (figure 7.8). Yet, emerging peers had smaller governments and grew faster than advanced regions. This suggests that there is no simple relationship between government size and growth at the regional level. A different look at the data reveals another picture. Figure 7.9 groups annual observations in four categories according to the share of government spending in GDP during that year. Both samples show a negative relationship between government size and growth, though the reduction in growth as government becomes bigger is far more pronounced in Europe, particularly when government size exceeds 40 percent of GDP.

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Figure 7.8: Government spending is higher in richer countries, and income growth is slower (median growth, percent, and median government size, percentage of GDP, 1995–2010)

Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on Eurostat; IMF WEO; OECD National Accounts Statistics; and WDI.

Since regional aggregates could hide a lot of variation across economies, it is worth analyzing the picture at the country level. Looking at initial government size allows us to rule out reverse causality: low growth or contractions could lead to higher government spending rather than the other way around. The Europe sample shows a clear negative relationship between government size and growth. Taken at face value, this suggests that big government lowers growth in Europe, but not for the world as a whole. This correlation might simply be picking up the impact of income levels. For example, growth was high in Armenia, Azerbaijan, and Georgia. This may be not so much because they have small government but because they are low-income countries benefiting from strong income convergence. And since government size tends to go up with higher-income levels, this leads to a spurious negative relationship between government size and growth. However,

Figure 7.9: Growth is slower as government gets bigger (median growth by average government size, percent, 1995–2010)

Note: The horizontal axis shows government spending as a percentage of GDP. Source: World Bank staff calculations, based on Eurostat; IMF WEO; and OECD National Accounts Statistics; and WDI.

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many governments in Eastern Europe are already the same size as some in Western Europe, even though their income levels are lower. In only 7 of 24 countries in Eastern Europe, governments spent in 2010 less than 40 percent of GDP. For the other 17, government size ranged between 40 percent and 50 percent of GDP, similar to spending levels in richer countries such as Canada, Germany, Norway, and the United States. Bosnia and Herzegovina, Hungary, Montenegro, Slovenia, and Ukraine stand out as countries with the largest excess spending. Since the crisis boosted government spending relative to economic activity more in advanced Europe than in emerging Europe, these comparisons were even starker before the crisis.

Big governments come with slower growth The standard way to isolate the impact of government size on growth from the impact of other variables is econometric analysis. A large economic literature explores the link between government size and economic growth, as reviewed in Bergh and Henrekson (2011), Barrios and Schaechter (2008), and Pitlik and Schratzenstaller (2011). Although many studies find a negative relationship between government size and growth, no consensus has emerged on whether big government is harmful to growth. The failure to establish robust findings is not unusual. The inherent difficulties of empirical growth studies, along with the importance of the subject, have led to a busy research area called growth econometrics (Durlauf, Kourtellos, and Tan 2008; Durlauf, Johnson, and Temple 2005). A practitioner of growth econometrics confronts four difficulties. First, the data are poor. Consistent national accounts data are available only since 1960, and only for some 100 countries. Data series for the countries from Eastern Europe start only in the mid-1990s. Second, there is “model uncertainty” because growth theories are not explicit about the salient determinants of growth. Third, macroeconomic analysis cannot exploit randomized trials as an investigation tool, making it difficult to establish causality. Fourth, growth econometrics has struggled to reconcile the desire to uncover common growth patterns across countries with the need to account for country-specific features as well as differences at different stages of countries’ growth processes (Solow 1994; Eberhardt and Teal 2011). For this chapter, we provide new econometric evidence on the impact of government size on growth using a panel of advanced and emerging economies since 1995. As estimates can be biased due to problems of omitted variables, endogeneity, or measurement errors, it is necessary to rely on a broad range of estimators. Depending on data availability and specification, the regressions in annex 1 report findings on 25–152 countries. The results show a robust inverse relationship between initial government size and subsequent growth in Europe, but not worldwide. The parameter estimates differ in size and significance, which is not surprising given the host of estimation issues. They suggest that a 10 percentage point increase in initial government spending as a share of GDP in Europe is associated with a reduction in annual real per capita GDP growth of around 0.6–0.9 percentage points a year (table A7.2). The estimates are roughly in line with those from panel regressions on advanced economies in the EU15 and OECD countries for periods

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Box 7.3: Europe’s tax burden is caused by high labor and indirect taxes—in spite of low corporate taxes Evaluating the impact of a country’s tax system on growth is no less a job than figuring out how public expenditures influence growth. This report does not attempt this task. Still, since taxation is central for growth and public finances, it does include a brief discussion. After all, taxes are the principal source of financing for public expenditures and the impact of an expansion of a particular government program depends always on how it is financed. Overall, Europe’s tax system is less growthfriendly than those of Anglo-Saxon countries and Japan because of a high tax burden and heavy reliance on labor taxes, but it is more growth-friendly because of low corporate tax rates and greater reliance on indirect taxes (Pitlik and Schratzenstaller 2011). • Europe’s tax take is high. This is especially true for the north and center, but even the EU12 countries in 2004–08 collected more taxes as a share of GDP than the AngloSaxon countries or the Republic of Korea. This is a concern, as high taxes are often a drag on growth. However, they are also often good for fiscal balances: fiscal deficits tend to be lower in countries with a high tax-to-GDP ratio.

• High personal income taxes are one reason why Western European countries collect high tax revenues. In addition, social security contributions are often high, giving rise to big marginal and average income tax wedges. So overall, labor gets taxed heavily. In contrast, many countries in Eastern Europe undertook reforms to reduce, simplify, and unify personal income tax rates, and their top personal income tax rates are now often lower than in AngloSaxon countries. Most studies find that workers with decent skills do not respond strongly to high labor taxes, but unskilled workers are discouraged from taking up formal work or working regular hours. High income taxes might also inhibit the development of markets that offer homeproduced services such as restaurants and personal services, as work at home becomes more attractive.

it does not distort production, distribution, or sales choices. In addition, many European countries impose sizable excise taxes on products such as tobacco, alcohol, and gasoline. Since their consumption can lead to bad health or bad air, such taxes not only generate revenues but may also improve society’s welfare as people cut back on these products in response to taxation. Property taxes in Europe tend to be less important than goods and services taxes, at least outside the center.

• Although European countries leverage high personal income taxes and indirect taxes, corporate income taxes are generally low. Why do some European countries levy high taxes on labor and low taxes on capital? The answer is that, as globalization showed up the mobility of capital and the immobility of labor, the efficiency costs of taxing capital heavily quickly became apparent. • European countries—especially the EU12— In the late 1980s, Scandinavian countries stand out in taxing goods and services began introducing dual tax systems, which more heavily than Anglo-Saxon countries combine low and uniform taxation of capital and Japan. Many European countries rely income with a higher and progressive on value-added tax (VAT) as the main taxation of labor income. Indeed, corporate indirect tax. Along with property taxes, VAT income tax rates have been cut around the is often considered among the taxes least globe in the last few decades, although harmful for growth. Since VAT taxes only fiscal concerns during the global crisis might consumption, it encourages exports. And as it is imposed on the whole production chain, have halted the trend for now.

from 1960 or 1970 to 1995 or 2005 (Bergh and Henrekson 2010 and 2011). This is by no means obvious. After all, our regressions cover a different and shorter period, and relate to a more varied group of countries. Among the 43 European countries, 18–24 countries were low- or middle-income economies in 1995–2010. A few points need emphasis: · In a race between the importance of initial per capita income and government size for growth, the former wins hands down. Growth declines with higher initial income both in Europe and the world. · The estimates for government size are consistently negative for Europe, but less so for the global sample. They are significant and negative for Europe ten times, but only three times for the world sample. · The results hold for two different time periods. Including all 16 years over the period 1995–2010 seems logical. But the global crisis led to a collapse in output in most countries, which inflated government size even without increases in spending programs. This is a case of reverse causality: a decline in growth leads to bigger government size, not the other way around. But the same analysis using data for 1995–2006 broadly confirms the findings for the whole period.

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· There can be threshold effects of government size, where size starts to matter only after it reaches a crushing mass. While the choice of a threshold for what constitutes “big government” is arbitrary, this chapter uses 40 percent of GDP, which is close to the average government size in high-income countries in 1995–2010.3 Tanzi and Schuknecht (2000), for example, suggest this as the upper limit for sufficient public spending. The results provide support for a threshold effect. The impact of government size on growth is negative for the countries with initial government spending of 40 percent of GDP or more, but positive (and mostly insignificant) for countries with smaller government sizes. The same pattern holds for the world sample. This might explain why government size is harmful for growth in Europe but not elsewhere. Median government expenditures over the last decade and a half were 26 percent of GDP in the world, but 43 percent of GDP in Europe. · Parameter estimates can be sensitive to the selection of variables. Sala-i-Martin, Doppelhofer, and Miller (2004) have used the method of Bayesian averaging of classical estimates (BACE) to find out which combination of these variables explains economic growth best. BACE uses all possible combinations and generates average coefficients for each variable, weighted by the goodness-of-fit of each regression, as well as inclusion probabilities. Our goal is more modest: to find out whether government size is one of the variables among the set of nine explanatory variables that contributes to a high explanatory power of the regression model. This implies running more than 500 regressions. The coefficient on government size is negative in both Europe and the world, but larger in absolute terms in Europe. The inclusion probabilities are in excess of 90 percent for Europe, but below 33 percent for the world. This confirms our findings of a robust negative relationship between initial government size and growth in Europe, but not in the world sample. · Government revenues can be studied as alternative measures of government size. Bergh and Karlsson (2010) argue that looking at tax revenues is one way to address concerns about reverse causality. Tax revenues as a share of GDP tend to increase during booms and decline during recessions (table A7.3). This makes it less likely that the causality runs from higher growth to lower government size. Since tax revenue data are harder to come by, total revenues have to be used rather than tax revenues. (For the sample of EU and OECD countries, tax revenues make up about 85 percent of overall revenues.) The results suggest that large public revenues come with slower growth (box 7.3).

Social transfers hinder growth—and public investments help Some types of public spending increase growth, others reduce it (for example, Lucas 1988; Barro 1990; Barro and Sala-i-Martin 1992; Gemmell, Kneller, and Sanz 2011). But the literature fails to agree on which categories of public spending are likely to be growth-friendly. Consensus is hard to come by because the growth impact of public spending is tied to a range of factors. Public spending programs can be executed well or poorly, and may work well in some stages of development but not others. High government consumption can reflect well-paid public servants who provide vital services to people

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and businesses, or it can be a sign of bloated and ineffective bureaucracies. Whether government spending turns out to boost or dampen growth depends also on the way it is financed. In short, public spending’s impact on growth depends on institutional, financial, and economic factors (Bayraktar and Moreno-Dodson 2010). Keeping these caveats in mind, we must ask: do social transfers hinder growth in Europe? Governments are big in Europe mainly due to high social transfers, and big governments are a drag on growth. The question is whether this is because of high social transfers. The answer seems to be that it is. The regression results for Europe, using the same approach as outlined earlier, show a consistently negative effect of social transfers on growth, even though the coefficients vary in size and significance (table A7.4). The result is confirmed through BACE regressions. High social transfers might well be the negative link from government size to growth in Europe. A sizable economic literature argues that, unlike social transfers, public investment more often than not supports growth. Over the last decade and a half, public investment was higher in Eastern than Western Europe, as a share both of GDP and of total public spending, reflecting three factors. Since the east is more capital-scarce than the west, the return on investment is likely to be higher there. Also, capital flows downhill in Europe, enabling emerging economies to boost investment. Finally, the EU’s structural funds allowed prospective and new member states to increase public investment. So, while the evidence is less clear-cut than for social transfers, it suggests that public investment is more likely to help than hinder growth in Europe.

Bumblebees can fly Big government is associated with slower growth in Europe. But the estimations discussed above pick up only the average patterns across Europe, and there are clearly countries that manage to combine big government with healthy growth. To return to the example at the start of this chapter, Sweden has managed to grow richer with big government, just as a bumblebee seems to defy the laws of aerodynamics. Sweden is not alone. In fact, the role of government has increased since the end of World War II in many countries, even during the “golden age” of European growth from the 1950s to the early 1970s. As market economies became richer, governments grew bigger. Government spending as a share of GDP among the G7 countries doubled from about 20 percent in 1950 to more than 40 percent in 2010. Big governments might be more commonly associated with paper reshuffling and red tape rather than the frictionless machinery imagined by Max Weber (Gerth and Mills 1946). Yet the persistent rise in government size suggests a deliberate choice of societies to expand government. The fiscal footprint of governments through taxation and spending is only one feature of government. A growing literature explores the role of government more generally. This research comes under different names, including quality of government, good government, governance, government capacity, or institutions. Institutional economists point out that the accumulation of physical, human, and intellectual capital—emphasized by neoclassical and endogenous

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growth theories as drivers of growth—are only proximate causes of growth. Institutions, along with geography, culture, and trust, are possible fundamental causes of growth that can explain why some countries fail to accumulate these forms of capital while others put them to good use and grow.

The five dimensions of government quality Poorly run governments result in improperly functioning markets, and wellrun governments can make up at least part of any negative effects of big government on growth. Does this happen in Europe? It appears it does. To answer this question, the relationship between government size and the quality of government in Europe and the world are contrasted. The approach of La Porta and others (1999) is adapted to establish whether government size is systematically correlated with quality of government, after considering economic, political, and geographic factors. Five government responsibilities are assessed: regulator of the private sector, facilitator of economic openness, manager of its resources, enabler of voice and accountability, and enabler and provider of public goods. · Establishing well-defined property rights and ensuring a functioning legal system is a core responsibility of government. Since the work of Adam Smith in the eighteenth century, the protection and enforcement of property rights and contracts has been seen as a precondition for the operation of markets and economic specialization. · Openness brings competition and pressures to improve productivity (Doucouliagos and Ulubasoglu 2006; Dreher 2006). It gives countries access to large, fast-growing markets that allow them to diversify and upgrade their products. Openness channels knowledge and technology through production networks, foreign direct investment, and learning from competitors. As chapter 2 discussed, Europe’s growth is also in good measure due to trade. Countries took their export-to-GDP share from 28 percent in 1970 to 54 percent in 2009 in Western Europe, and from 36 percent in 1995 to 49 percent in 2009 in Eastern Europe. · The government can run more or less efficient bureaucracies. With governments commanding around 40–50 percent of GDP, productivity in the public sector, while hard to measure, is a key driver of growth. Managing civil servants well, keeping a cap on the public sector wage bill, and borrowing tools from the private sector to run services efficiently are all important to keep the public sector lean and productive. · Voice and accountability capture important aspects of European countries. Citizens’ voice in society and participation in politics connect them to politicians and policymakers who represent government. Elections and informed voting can make political commitments more credible and produce better outcomes. In addition, better information, thorough public disclosure, citizen-based budget analysis, service benchmarking, and program impact assessments and an active independent media can strengthen voice and accountability (World Bank 2004).

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Figure 7.10: Quality of government declines from north to south and west to east (rule of law (left) and trade openness (right) [exports and imports as percentage of GDP], median, 1996–2000 and 2006–10) (government effectiveness (left) and political stability (right), median, 1996–2000 and 2006–10)

(income equality (100 – Gini coefficient), median, 2000–06)

Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on Worldwide Governance Indicators (Kaufmann, Kraay, and Mastruzzi 2010); IMF WEO; and UNU-WIDER 2008.

· Ensuring the supply of public goods such as health care or education is another responsibility of government, whether as provider, financier, or regulator. The quality of government varies considerably across Europe. Figure 7.10 shows one illustrative indicator for each of the five dimensions. In Western Europe, the south does worse than the north or center in level, and, from the late 1990s to the late 2000s, in change. In Eastern Europe, the EU12 countries stand out as the best performers. Indeed, even though their per capita income is still only about three-quarters of the south’s, they match the south on several indicators. The dimensions of government quality are interlinked. For example, voice and accountability, along with social trust, makes public programs accessible for lower-income households (Lindert 2004). Combined with a progressive tax system, this heavily reduces income inequality. OECD figures, for example,

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Figure 7.11: Governments reduce inequality more in Europe (Gini coefficients of income inequality before and after taxes and transfers for mid-2000s)

Source: OECD Income Distribution and Poverty Database.

suggest that the impact of Europe’s public spending and taxation is more redistributive than in the Anglo-Saxon countries or Japan (figure 7.11; see figure 1.15 in chapter 1). As a result, the income distribution (after taxes and transfers) is more equal in the north, the center, and the EU12 (not in the south) than in the Anglo-Saxon countries and Japan. Atkinson, Piketty, and Saez (2011) argue that this greater equality is also related to Europe’s greater ability to ensure that households at the top of the income distribution contribute adequately to government finances. For example, while the share of the top 1 percent of households in total after-tax earnings remained unchanged over the last four decades at about 11 percent in Germany, it increased from 9 percent to 20 percent in the United States.

Big, high-quality government A fairly consistent pattern emerges from the analysis in this chapter. Big government is systematically correlated with better quality of government, with two exceptions: collective wage bargaining and tax rates. This holds both for the world sample and for Europe. It holds also for all five dimensions of government quality. And it holds in most cases, even when we control for basic economic, political, and geographic determinants of institutions (table A7.6). · Big government is associated with better enforcement of property rights, better regulation, and more independent judiciaries in both the world sample and Europe. Big governments come with more centralized collective bargaining, though there is no correlation with dismissal cost of workers in Europe. In addition, while tax compliance costs are not related to government size, income tax rates are higher in countries with big government. Clearly, for both labor markets and taxes, it is necessary to look at how systems work as a whole, country by country. · Big government is related to economic globalization elsewhere, but not in Europe. Tariffs go up with government size generally, but not in Europe, perhaps because of the EU’s common external tariff. In Europe, countries’ trade shares are not related to government size.

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Box 7.4: Nordic social protection programs seem to be different Nordic countries stand out for large spending on social protection outside pensions. This includes support for child care and women’s careers as well as active labor market policies. Generous social benefits lead to high taxes and large tax wedges, which might undermine growth. But the Nordic countries have streamlined their welfare systems and reduced incentive costs over the last two decades, while maintaining comprehensive insurance against economic, social, and health risks. For jobs, the system combines flexibility for firms with security for workers, to facilitate structural change and job creation. A worker whose living standards are protected through

a social welfare system has to worry less about losing his or her job. By protecting workers and not jobs, governments can foster job creation and destruction and keep the economy productive. Job search assistance is individualized and provided with light bureaucracy.

benefits are prorated for part-time work. Since entitlement to programs does not depend on income, universalist programs ensure that low-income earners can improve their income by taking up work. They help to keep administrative costs down because targeted benefit entitlement is hard to determine. They also benefit from strong political support. At the same time, the recipient of social benefits has to meet certain obligations, including welfare-to-work elements.

Investment in skills and careers of mothers can also help job creation and income growth. Women will find it easier to combine family and work with a publicly funded infrastructure of affordable and quality child care, generous parental leave, and options for part-time Source: Aiginger 2004; Kielos 2009; Rodrik, work. Part-time work is encouraged, allowing women to combine family and work, and social Subramanian, and Trebbi 2004.

· Big government is related to effective government, better control of corruption, and small informal economies in both the world as a whole and in Europe. Low informality means, for example, a larger tax base, which in turn makes it easier to fund big government without imposing high taxes. These correlations also hold when controlling for other institutional determinants. · Big government goes with stronger institutionalized democracy, more voice and accountability, and greater political stability. This holds in the world and Europe, with and without additional covariates. · Big government does well with public goods. It is correlated with higher years of schooling, lower infant mortality, longer healthy life expectancy, and more equality in both the world and Europe. The relationship remains significant with the exception of schooling in Europe when controlling for other determinants.

Social trust makes for “big government lite” Countries with efficient courts, open and deregulated economies, and impartial, honest, and accountable public administrations find it easier to combine big government with growth and well-being. Yet, efficient, high-quality government is a fairly recent phenomenon, limited to some high-income countries. For most countries for much of their history, governance was drenched in endemic corruption, patronage, and abuse of power. But given the importance of the right institutions for well-being, how is it that some societies maintain institutions that perpetuate economic failure? Turning bad governance into good governance could well require more than just a technical fix or a political push; it needs, rather, a profound change in institutions. Yet, such change takes time, as the seeds for strong institutions in some countries go back at least to the nineteenth century. And there is likely to be resistance to change. Acemoglu, Johnson, and Robinson (2005) argue that different institutions not only have different implications for economic growth,

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but also for the distribution of the rewards from growth across different groups. Those groups that command the largest resources will push for economic and political institutions favorable to their interest, thus perpetuating their hold on power. There is another factor, beyond profound institutional change, that matters. Developing good institutions may well be easier in countries with high social trust, where people are less worried about others taking advantage of the system. They abide by the rules not because of enforcement but social trust. Low welfare fraud and tax evasion allow the public sector to function more efficiently. And while social trust does not stop governments from becoming too big, it can raise the threshold at which big government becomes a drag on growth and well-being.4 As social trust facilitates good institutions, and big government often relies on good institutions, is big government also correlated with strong social trust? We extend the regression specification used in the last section to look at this issue using World Values Survey data (table A7.7). We find, indeed, that big government tends to be correlated with high social trust, though the coefficients are not always significant, especially when we control for other institutional determinants. Big government is associated with more trust in other people, more tolerance of diversity, the opinion that government should take more responsibility, and the view that claiming benefits is justified (box 7.4). So strong quality of government and social trust go a long way toward explaining how a country like Sweden manages to grow fast with big government (box 7.5). Of course, even in countries with strong social trust and good quality of government, governments can be too big. But strong institutions help countries to undertake successful fiscal consolidation. For example, in 1993, Sweden’s economy was in recession and the public finances in dire straits. General government expenditures reached a record high of 72 percent of GDP, and the fiscal deficit ran at over 12 percent of GDP. Sweden put together a strong fiscal adjustment package to meet the EU Maastricht criteria. The program was successful: growth returned quickly and the fiscal balance turned positive within five years.

Box 7.5: The north performs better than predicted in the models, and the south and the EU candidate countries worse We have looked at Europe as a whole in our analyses of growth, quality of government, and trust. For example, we assumed that the growth model is the same across the west and east, or the north and south. Yet, to paraphrase a remark from the econometrician Harberger (1987): What do Greece, Sweden, and Ukraine have in common that merits their being put in the same regression analysis? This point is especially valid in the current context where we try to analyze why countries like

Sweden can defy the growth moderation coming from big government.

Europe, are simply too short for meaningful analysis. Instead, we use a simpler approach: we illustrate the regional differences by One way to address this point would be to the differences in how well our models estimate country-specific models. Values of predict actual values of growth, quality of parameter, and not just variables, could then government, and trust. The pattern is fairly vary from one country to another. However, uniform: the north does better than predicted the tradeoff would be that we lose the insights by our models for all indicators; the south does from unveiling common characteristics across worse for all indicators; and the EU candidate a group of countries. In addition, time series countries do worse on all indicators except trust. for individual countries, especially in Eastern

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Other Northern European countries have carried out similar reforms since the early 1990s, building on a long tradition of quality in public service: Many of the northern European countries that started to develop encompassing welfare states during the first half of the twentieth century had successfully increased their quality of government during the preceding century. For example, during the nineteenth century Bavaria, Prussia, Britain, Denmark, and Sweden carried out large-scale changes in their government institutions that did away with systemic corruption and pervasive patronage and introduced impartial (meritocratic) systems for recruiting civil servants and implementing public policies. (Rothstein 2011, p. 126)

Doing more with less With governments financially squeezed for a long time to come, making public sectors work better has become a main motivation for public finance reforms. Looking for ways to reduce fiscal imbalances and to lower public spending, governments in Europe and elsewhere are seeking ways to improve the efficiency of the public sector. Standard policy prescriptions include making budget processes more responsive, reforming management practices, improving information and accessibility through e-government, using market signals for publicly provided goods, and enlisting the private sector and communities to deliver services. Collaboration with others can take many forms: transferring revenues to subnational governments and mandating service provision; contracting with commercial companies to supply public goods; and entering public–private partnerships to finance, build, and operate infrastructure projects and other public projects. If done well, such reforms can reduce public bureaucracy and increase the productivity of services by introducing practices from the private sector. If done poorly, they can lead to high transaction costs and replace public with private red tape—without improving services. Ultimately, high-quality government is needed to outsource well, too. Outsourcing, whether directly to the end user or for government inputs, amounted to 10 percent of GDP in OECD member countries in 2009. The Netherlands, the leader, outsourced almost twice that. With public wages absorbing about one-quarter of total government spending, reining in public sector pay is a potentially powerful instrument for improving public sector efficiency (Clements and others 2010). Indeed, the north and the center (and Japan) managed to keep a cap on public wages relative to GDP after the mid-1990s, when public sector wages rose in other regions, though higher public sector pay there rarely translated into better public services. More recently, in response to the global crisis, many countries have imposed nominal freezes or cuts in employees’ remuneration and hiring, or have streamlined bonuses and allowances. Such actions can be important to shore up macroeconomic stability by lowering the wage bill. More systemic changes are also often needed, however, including rationalizing the size and structure of the public sector, strengthening payroll systems, and tightening the link between pay and performance. While they take longer to implement, if done

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Box 7.6: Private social spending is low in Western Europe, especially the south Public and private expenditures are to some degree substitutes. For public services, families pay taxes and social security contributions to the government. For private services, households pay fees to the private school or health center. Of course, families might be able to select their preferred type of service in a better way and to hold the service provider accountable in the private sector. Nevertheless, the impact on family income

might be similar, whether the school or health center is public or private. Indeed, once one accounts for private health insurance, the U.S. tax burden is no longer far below Western European levels. Accounting for private social expenditures gives a better picture of the national resources invested in social sectors. The Organisation for Economic Co-operation and Development

presents numbers for private social spending by 26 member countries for 2007 (box figure 1). The United States stands out in its heavy and increasing reliance on private social spending. But Western Europe also lags the other Anglo-Saxon countries, as well as Japan and the Republic of Korea. In Western Europe, private social spending matters least for the south and most for the center.

Box figure 1: Private social spending for OECD countries, 2001 and 2007 (percentage of GDP)

Source: Adema and Ladaique 2009; and OECD Social Expenditure Database.

well, systemic reforms can make the adjustments sustainable and give a boost to public sector efficiency.

Measuring public sector performance is hard Making the public sector work better might well be harder than doing the same thing for the private sector. Let us take the case of civil servants. Improving their incentives to perform well through bonus payments is difficult without good measures of what they produce. Yet, public sector outputs are often indivisible and their production function is unknown. And since the output of civil servants is hard to define and seldom priced in markets, it is intrinsically hard to measure their productivity and to reward them according to their contribution to output. Because putting a value on the output of governments is difficult, national accounts therefore typically assume that the value of that output is simply equal to the total cost of the input. This implies that larger public spending translates one for one into larger output, rendering investigations of public sector productivity based on national accounts data meaningless.

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Figure 7.12: Private spending makes the United States the biggest health care spender in the world (private and public health spending, percentage of GDP 1995-2009)

Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on WHO Global Health Expenditure Database.

The issue is not just about measuring output. The uncertainty about public sector output might make it easier for bureaucracies to appropriate some of the surplus that otherwise would belong to taxpayers, at least as long as politicians and citizens cannot exercise appropriate control. Although measuring government output is tricky, economists often adopt a methodology originally designed for firms. Taking education and health as examples, the idea is to relate the amount of public resources to outputs and outcomes, such as education enrollment rates or life expectancy. The results show that differences in performance and efficiency across countries are substantial; that there is no systematic link from more government spending to higher efficiency; and that public sector efficiency relates systematically to income levels, institutional factors, and demographic trends (Hauner and Kyobe 2010; Tanzi and Schuknecht 1997 and 2000; Alfonso, Schuknecht, and Tanzi 2005; Afonso, Schuknecht, and Tanzi (2010); Mandl, Dierx, and Ilzkovitz 2008; Estache, Gonzalez, and Trujillo 2007). Analyzing public sector performance and efficiency is not easy. In particular, the link between public spending and social outcomes is often tenuous. Public spending is only one among many factors explaining public sector performance, including a host of economic, social, and institutional variables. In addition, comparing public expenditure ratios across countries assumes that public sectors have a homogenous production function. Nevertheless, these attempts to measure public sector performance serve a purpose. Comparisons of the performance of public sectors are inevitable, so this is best done in a rigid and transparent fashion rather than using more or less ad hoc approaches. The following sections present three ways to analyze public sector performance. First, we link public spending on education and health to secondary school enrollment rates and maternal mortality ratios. Then, we illustrate potential inefficiencies in education using examples from Eastern Europe. Finally, we discuss how governments have adjusted spending on pensions and other social transfers in response to population aging.

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Figure 7.13: Western Europe has good health and education outcomes (maternal mortality ratios (left) and net secondary enrollment rates (right), 1995–2009) Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on data from WHO and UNESCO.

Public spending is more effective for health care than education Health and education absorb sizable amounts of Europe’s public spending in social sectors, although public health spending is higher in Anglo-Saxon countries and Japan than in Western Europe. Eastern Europe spends less on public health, despite the fact that eastern partnership and especially EU candidate countries have increased their spending in the last decade. The north leads education spending in Western Europe, and the EU12 countries in Eastern Europe. Anglo-Saxon countries spend almost as much as the north, while Japan spends less than the center and the south. Despite shrinking school cohorts, EU candidate and eastern partnership countries raised education spending over the decade. Taking health and education together, Anglo-Saxon countries spent as much as or more than Western European countries, even though they rely more on private spending than Western Europe (box 7.6). In Europe, private health spending is highest in the eastern partnership countries (figure 7.12). How effective are public resources in improving health and education outcomes? It is illustrative to compare the impact of government spending on maternal mortality ratios and net secondary enrollment rates. The maternal mortality ratio—the number of maternal deaths per 100,000 live births—is

Box 7.7: Randomized public health, Oregon In 2004, Oregon closed its public health insurance program for low-income people for lack of public funds. By 2008, it had enough resources for 10,000 people. Because 90,000 people were on the waiting list, a lottery was used to select the people who can apply. Analyzing the impact of public health insurance on people’s health, Finkelstein and others (2011) write: “This lottery provides a

unique opportunity to gauge the effects of expanding access to public health insurance on the health care use, financial strain, and health of low-income adults using a randomized controlled design. In the year after random assignment, the treatment group selected by the lottery was about 25 percentage points more likely to have insurance than the control group that was not selected. We find that in this first year, the treatment group had

substantively and statistically significantly higher health care utilization (including primary and preventive care as well as hospitalizations), lower out-of-pocket medical expenditures and medical debt (including fewer bills sent to collection), and better selfreported physical and mental health than the control group” (from abstract). Source: Finkelstein and others 2011.

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often used as a measure of the quality of health care, and is correlated with infant and under-five mortality rates. The net secondary enrollment rate provides a measure of the extent to which the population eligible to participate in secondary education is actually enrolled. Net rates are a more precise measure of participation than gross rates as they exclude over-age and under-age children. However, enrollment rates do not measure the quality of education and learning achievements. The analysis contrasts the impact of public spending on health and education outcomes as measured by these two indicators. This exercise is merely suggestive, as a proper consideration of health and education would require a more disaggregated look at inputs and outputs for a range of outcomes. Figure 7.13 shows the geographic variation of the performance measures. Maternal mortality ratios are far lower, and net secondary enrollment rates somewhat higher, in Western than Eastern Europe. As a measure of the quality of government, we use the commonly used International Country Risk Guide indicator averaged over the dimensions of corruption, law and order, and quality of bureaucracy. We interpret this indicator as a broad measure of government effectiveness. As we saw earlier, quality of government declines in Europe as we move north to south and west to east. How does the impact of public spending vary across the two outcome measures? (The regression results are summarized in table A7.8). For maternal mortality, a 1 percent increase in government spending leads to a 1 percent reduction in the maternal mortality ratio. By contrast, we find that the elasticity of public spending on education with net secondary enrollment rates is only 0.2, suggesting that spending on health is effective than on education. Similarly, analyzing 114 countries over 1980–2004, Hauner and Kyobe (2010) argue that the link from more public spending to better performance is more tenuous in health than in education. What might account for these differences between the two sectors? One interpretation is that public spending is more effective in promoting good health care than good education because of the different nature of the services. In particular, infrastructure and equipment play a bigger role in health than education. In addition, there is a fundamental difference between health and education in most countries: education is delivered by the public sector; health is purchased by the public sector even though it owns some of the institutions. For all its problems, health may have been far more effectively privatized than education as far as provision is concerned (except at tertiary level). Furthermore, the public sector seems better able than the private sector to control costs for health care and to give access to a broad spectrum of people without any major loss in the quality of services, when one contrasts the experience of the United States with that in other countries (box 7.7). A final interpretation would be not so much about why public health spending works, but why public education spending does not. One aspect is that private spending might be better able to substitute for public spending in education. Another aspect is that public education systems might suffer from inefficiencies. The next section illustrates these inefficiencies in three countries.

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Identifying inefficiencies in government spending: three examples Europe has made great achievements in the education sector, and education has made a vast contribution to growth and prosperity over the last half century. In the early 1960s, only the privileged benefited from higher education, while today about one in three young adults has a tertiary degree (OECD 2011a). While there are many good things to say about education, this section presents three examples of inefficient government spending on education and highlights policy responses aimed at improving sector efficiency that have been suggested in recent World Bank reports. Moldova: adjusting the school network to changing demographics. Like many of its neighbors, the country has experienced a steady population decline in the past two decades. Lower birthrates combined with high levels of emigration have also led to a sharp aging of the population—particularly in rural areas— resulting in 43 percent fewer students in Moldova’s schools over this period. But the school network has failed to adjust to the demographic changes: the number of teachers employed in 2009 was the same as in 2003, while the number of schools was virtually unchanged from 1994. The average school now enrolls 160 fewer students than it did in the early 1990s, with student–teacher ratios dropping from 14.5 in 2003 to 10.4 in 2009. Shrinking schools and classes have caused education to become a drain on public resources, its spending surpassing 9 percent of GDP by 2009. Recent work at the World Bank examined the expenditures in Moldova’s general education subsector and identified fiscal savings from optimizing the country’s school network. The government will have to do a lot: increase class and school sizes in rural areas by consolidating and closing underutilized schools; raise class sizes in large schools by consolidating small classes; implement nationwide per student financing of general education; and overhaul the legislative framework governing education to allow for a more efficient use of resources in line with actual needs, instead of ensuring compliance with outdated norms. The fiscal savings resulting from the proposed reforms—estimated to exceed 7 percent of the general education budget—can then be used to improve the quality of education by investing in infrastructure, teacher training, technology, learning materials, and so on. Poland: aligning spending with results in a decentralized education system. Poland’s education reforms are considered a great success. By restructuring schooling, deferring tracking in secondary education, launching curriculum reform, and boosting school autonomy, between 2000 and 2009, Poland rose from below to above the OECD average in the OECD Programme for International Student Assessment reading scores. Not all aspects of the reform have worked equally well. The decentralization reforms of the 1990s devolved responsibility for managing primary and secondary education to local governments (Rodriguez and Herbst 2011). In primary education (grades 1–6) most direct financing decisions are now made by the municipality (gmina), allowing for wide variations in funding and other inputs for primary schools across the country’s more than 2,000 municipalities.

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Given the high degree of discretion in municipalities’ decisions on how—and how much—to invest in primary education, one may ask whether municipalities that spend more per student receive a higher return on this investment in the form of better educational outcomes than similar municipalities with lower levels of spending. It seems not. Recent World Bank analysis found no relationship between municipal spending on primary education and grade 6 test scores when municipalities’ demographic and socioeconomic characteristics were taken into account. This finding raises another question: Why do some communities get less from spending on education than seemingly similar but more “efficient” communities? For a possible explanation, consider two rural communities. The village of Rutka-Tartak spent less than half as much per student as did Tarłów village, yet its students scored significantly higher on the national grade 6 exam. The two municipalities are similar—population density, household structure, adult education levels, and so forth—yet one community seems to be “more efficient” in converting inputs proxied by spending per student into outcomes, as measured by standardized test scores. The difference in unit costs between Tarłów and Rutka-Tartak is explained in large part by the difference in average class sizes across the two municipalities. While one municipality groups students, on average, in classes of 24, the other has smaller classes of 15 students. Smaller classes increase unit costs but do not appear to contribute to improving education outcomes. In short, this suggests that some of Tarłów’s resources could be saved with little impact on the quality of education of its primary schools. Armenia: protecting equity while ensuring quality of rural schools. A major concern in deciding how to allocate public resources in education arises from the goal of ensuring adequate access to high-quality education for all children. The focus is often on protecting access for vulnerable children, such as those from households with poor or less educated parents or in remote rural areas. In Armenia, the government’s policy of providing equal access to education is manifest in a large network of small rural schools that allows virtually all students to attend school in their village—Armenia averages one school per village. The question is: While this raises the unit costs of education, does it foster equality by providing high-quality education to vulnerable students? Sadly, no. The government’s policy of maintaining a vast network of small rural schools is not only fiscally inefficient but also fails to provide high-quality education to the target student population. The average allocation per student under the country’s per capita financing formula is nearly three times as high in the smallest schools as the national average. By itself, this is not surprising given the financing formula’s generous fixed per school component and the government’s commitment to funding schools in even the smallest villages. But more detailed analysis revealed a persistent gap in student achievement between urban and rural schools and between large and small schools. Of the students who took the university entrance exam at the end of the 2009/10 academic year, those attending the smallest schools were almost 20 percentage points less likely to pass. These students were also less likely to take the unified

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Figure 7.14: The south spends more on pensions than others (public pensions, percentage of GDP, 1995–2000 and 2007–08)

Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on Eurostat; and OECD Pensions Statistics.

entrance exam. After controlling for a variety of demographic, socioeconomic, and geographic characteristics of the communities where these schools are located, it was still the case that the achievement gap between small and large schools remained. The inability to ensure equal quality of education for rural students undermines the rationale for spending heavily on maintaining small schools in the more than 800 villages. The World Bank study recommended that the government consider shifting its focus from providing access to a school building in every village to ensuring access to high-quality education for every student. Potential measures include assessing the quality of education provided by rural schools, adjusting the per capita financing formula, addressing the low quality of teaching in rural areas, and finding better ways of providing education to students in rural areas by, for example, forming fewer “hub schools” for groups of villages. With more informed analysis and a willingness to experiment, equity and efficiency in public service provision need not be conflicting objectives. These three country examples illustrate how inefficiencies in government spending can be caused. One is the public sector’s inability to adjust spending patterns to shifting demographic trends (Moldova). Another (Poland) is that devolving spending decisions to local governments creates a laboratory that can illustrate the impact of different resource allocation decisions on results in otherwise similar municipalities. The challenge is for municipalities to learn from each other and adopt winning solutions. And last (Armenia), government policies that seek to improve equity at the expense of efficiency may achieve neither without proper evaluation of the policies’ outcomes.

Aging and social transfers An aging population puts pressure on pension systems. But who bears the costs? Is it the working-age population who have to pay more taxes or to face cuts in family benefits imposed by the politically powerful elderly? Or does the burden fall on the elderly through less generous pensions? Population aging in the last three decades is almost a global phenomenon, but to different degrees in different regions. Taking 1980 as the benchmark and the

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Box 7.8: Some countries have managed to reform pensions in spite of a growing elderly population Australia, a leader in pension reforms, has a near-universal system of mandatorily funded employer pensions. In the late 1990s, Canada raised the contribution rate for the public pension system well above current costs to build up a large trust fund for the future. Germany, Japan, and Sweden have all indexed their public pensions system, at least partly, to changes in longevity. Germany has also taken steps to encourage funded private pensions. Italy began in the early 1990s to adopt reforms to scale back benefits, though with long transition periods. The Netherlands has a large, nearly universal, and fully funded occupational pension system, allowing the public pension system to be relatively modest. In the late 1990s, Sweden introduced a new system of national defined contribution accounts along with a mandatory system of personal retirement accounts. Many countries

are cutting back expensive early-retirement options. The United States has a modest public pension system thanks to a large funded private system and a young population. On the basis of median voter models, Razin, Sadek, and Swagel (2002) and Galasso and Profeta (2004) argue that aging could either increase or decrease the size of social welfare depending on whether the political effect or the economic effect dominates. Population aging makes the median voter older, and hence increases that person’s demand for social welfare spending (the political effect). Aging also leads, however, to a higher tax burden on the median voter as the share of the old-age population increases, and this could reduce the median voter’s preference for social spending (the economic effect). Empirical analysis suggests that population aging is linked to higher social spending. Disney (2007),

for example, uses fixed-effect panel analysis to show that demographic aging is associated with a larger welfare state using data from 21 Organisation for Economic Co-operation and Development (OECD) countries for the 1970s to the 1990s. Using similar data and an error-correction specification, Sanz and Velázquez (2007) establish that aging is the main driving force in the growth of government spending. Likewise, Tepe and Vanhuysse (2009 and 2010) analyze OECD countries from 1980 to the early 2000s and find that population aging drives up pension spending, but not health spending or welfare programs for families and the unemployed. In addition, Capretta (2007) and Meier and Werding (2010) find that the increase in aggregate spending on pensions is mitigated by reductions in the generosity of benefits.

old-age dependency ratio as the indicator, it was most rapid in Japan and the Republic of Korea. In Europe, it was fastest in the EU candidate countries, the eastern partnership countries, and the south. Populations in the north and the center aged relatively little. But the regions started at different points. Despite rapid aging, Korea and Eastern Europe still have fairly young populations. In 2009, for each person age 65 or older there were seven working-age persons in Korea, but only three in Japan. In Europe, there were more than five workingage persons in EU candidate and eastern partnership countries, but only fewer than four in the south. The trends in public pension spending since the mid-1990s also reveal notable differences across regions. As a share of GDP, public pension spending increased in the south, the EU candidate countries, and Japan, but decreased in the north, the EU12, and the Anglo-Saxon group (figure 7.14). Comparing the trends in public pensions spending with population aging gives us a way to assess whether spending on public pensions is driven mainly by demographics or also changes in generosity and coverage. A good indicator is the pension support ratio (Lindert 2004), which is the public pension per elderly person relative to GDP per worker or, alternatively, the ratio of the share of public pensions in GDP relative to the share of elderly in the working-age population. This section looks first at OECD countries over 1980–2007, and then extends the analysis to Eastern Europe for 2000–2007/08. A similar approach is used to look at changes in social transfers. For a group of 20 OECD countries, we find that pension payments increased over and above aging pressures only in the south, especially in Greece and Portugal. In other regions, pension payments increased in line with the rising share of the elderly in the working-age population (the north and Japan) or even declined due to a tightening of generosity (the center and Anglo-Saxon).

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Figure 7.15: The burden of social transfers grew most in the south (trends in social transfers, 1994 and 2008, 1990 = 100)

Source: World Bank staff calculations, based on Eurostat; OECD National Accounts Statistics; and WDI.

Figure 7.16: The eastern partnership countries increased social transfers the most (trends in pensions and social transfers, 2007/08, Eastern Europe)

Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on Eurostat; and WDI.

In addition, there is a notable shift in pension policy in the mid-1990s in the north and the center. Up to the mid-1990s, public pension pressures tended to increase over and above population aging partly due to policies to encourage early retirement. In response to the economic recession and rise in unemployment in the early 1980s, some countries encouraged early retirement of workers because rigid labor laws made it difficult for enterprises to lay off workers. By contrast, with growth and income convergence with other EU countries, the south responded to rising expectations of its populations in the 1990s by adopting the former social benefit norms that the north and the center were beginning to tighten. There is a remarkably consistent pattern in the links between aging and spending (table A7.9). In 1980–94, for all OECD countries as well as just the European OECD countries, a 1 percent increase in the old-age dependency ratio triggered roughly a 1 percent increase in public pensions as a share of GDP. In other words, the pension support ratio remained constant, as public pension spending increased in line with population aging. In 1995–2007, the elasticity of the old-age dependency ratio for public pension payments was less than unity. Furthermore, it was smaller for European OECD countries (around 0.6–0.7) than for all OECD countries (around 0.8–0.9). In other words, the pension support ratio declined. Countries reduced the generosity of pension payments to limit the rise in public pensions as population aging became more pressing. Led by the north and the center, pension reforms helped mitigate the fiscal impact of population aging. These findings confirm the results in the literature (box 7.8).

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Figure 7.17 Public debt rose everywhere during the crisis except in the emerging peers (fiscal balances (left) and gross public debt (right), percentage of GDP, 2008 and 2010)

Note: “EU cand.” refers to EU candidate countries. Source: World Bank staff calculations, based on IMF WEO.

A slight modification allows a similar assessment for social transfers (table A7.10). Since social transfers include various family, child, and unemployment benefits, the dependent population has to be redefined to include the elderly, the population under 15 years old, and the unemployed. As before, we relate this dependent population to the working-age population. Of course, such analysis is simplistic, as the link between demography and social transfers is more complicated. For example, social transfers include social assistance—not just unemployment benefits but also payments linked to sickness, disability, and maternity. Figure 7.15 shows the trends in social transfer indicators relative to 1990 for the 19 OECD countries with data. In 1990–94, social transfer payments grew faster than the dependency ratio in all regions. After 1994, the social transfer support ratio improved substantially in the north, and deteriorated in the south and Japan. Regression analysis confirms this pattern, even though the coefficients are seldom significant. Including all countries with data from 1980, we find that the elasticity of the dependency ratio for social transfer payments declined after 1994, and more so in Europe than for the whole OECD sample. The discussion so far has looked only at OECD countries. The data also permit a review of the changes in pension payments and social transfers in Eastern Europe since 2000. Some of these countries carried out pension reforms by modifying pay-as-you-go systems into multipillar systems (figure 7.16). These include Hungary and Poland in the 1990s, and Bulgaria, Estonia, Latvia,

Box 7.9: Debt and growth Reinhart and Rogoff (2010) analyze the relationship of growth and debt for 44 countries over about 200 years. They sum up their main findings as follows:

public debt is similar in advanced and emerging economies and applies for both the post–World War II period and as far back as the data permit (often well into the 1800s).

First, the relationship between government debt and real GDP growth is weak for debt-toGDP ratios below 90 percent of GDP. Above the threshold of 90 percent, median growth rates fall by 1 percent, and average growth falls considerably more. The threshold for

Second, emerging markets face lower thresholds for total external debt (public and private)—which is usually denominated in a foreign currency. When total external debt reaches 60 percent of GDP, annual growth declines about 2 percent; for higher levels,

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growth rates are roughly cut in half. Third, there is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt-toGDP is high). The story is entirely different for emerging markets, where inflation rises sharply as debt increases. Source: Reinhart and Rogoff 2010.


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Figure 7.18: Markets have learned to look at fiscal vulnerabilities (five-year credit default swap spreads and public debt, mid2008 and August 2011)

Note: Dark blue dots represent EU15 countries, and light blue EU12 economies. Source: Eurostat; and Bloomberg.

Lithuania, Romania, and the Slovak Republic in the 2000s. These reforms moderated the impact of population aging on public finances. But eastern partnership countries lag their European peers in these reforms. In addition, they also expanded social transfers faster than increases in the dependency ratio, as they appear to have responded to the expectations of people to meet the social standards of Western Europe. Naturally, Western European countries can be more generous; they can mobilize resources for social programs more easily, possibly with smaller disincentive effects on work.

Getting the fiscal house in order With the economic recovery losing steam three years after the Lehman crisis broke, governments in Europe would like to focus on creating jobs and generating growth. Instead, they are confronted with a public debt crisis. In many countries, putting the fiscal house in order has become the main preoccupation of policymakers for five reasons: the size of government, fiscal deficits, and public debt have risen due to the economic crisis, boosting the scale of the fiscal challenge; learning from the crisis, financial markets have turned their attention to potential fiscal vulnerabilities; the postcrisis growth prospects look uncertain, making fiscal adjustment more difficult; population aging will accelerate in the coming decades; and restoring the ability of fiscal policy to respond will help prepare for future crises.

A bigger fiscal challenge Even without the crisis, governments in Europe already had large public sectors. During the crisis, government expenditures increased even further. In 2010, expenditures reached more than 50 percent of GDP in Western Europe and 42 percent of GDP in Eastern Europe, the highest in a decade and a half. The crisis also led to an unprecedented peacetime deterioration in fiscal balances as the revenue base collapsed, GDP contracted, and government spending rose to stabilize the economy and mitigate social impacts. The median general government deficit jumped from 0.5 percent of GDP in 2008 to 4.7 percent in 2010 for Western Europe and from 2 percent to 4.2 percent in Eastern Europe (figure 7.17).

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Figure 7.19: The biggest declines in growth will be in Europe (growth (left), percent, 2003–08 versus 2011–16; output gap (right), percentage of GDP, 2003–08 versus 2011–16) Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on IMF WEO.

In Western Europe, the increase in deficits was the largest in the north. Nevertheless, the 2010 fiscal deficits of the north remained among the lowest in Europe, as this region had run fiscal surpluses before the crisis. By contrast, the already weak fiscal position of the south deteriorated further. In Eastern Europe, the deterioration in fiscal deficits was less striking and similar across the three groups, as governments were less active in supporting domestic demand and stabilizing the banking system. The large increases in fiscal deficits—and to a lesser extent governments’ acquisition of unhealthy banks’ financial assets—sharply raised public debt-toGDP ratios. The median general government debt increased from 57 percent of GDP in 2008 to 74 percent of GDP in 2010 in Western Europe. Of 18 countries in Western Europe, 5 had public debt-to-GDP ratios higher than 90 percent in 2010 (box 7.9). Public debt ratios increased from 25 percent of GDP in 2008 to 39 percent in 2010 in Eastern Europe. Of the 25 countries in Eastern Europe, 11 had debt above 40 percent of GDP. High public debt ratios put pressure on real interest rates and dampened growth prospects. International evidence suggests, for example, that a 10 percentage point increase in the public debt-toGDP ratio leads to a rise in long-term interest rates of 30–50 basis points, and a slowdown in growth of 0.15 percentage points a year (Kumar and Woo 2010). For most countries, the increase in public debt has not triggered increases in public debt service burdens because of low interest rates. However, markets pay close attention to fiscal deficits and public debt burdens and so, though government bond spreads in the European Union bore little relation to public debt before the crisis, bond spreads are now rising with higher public debt (figure 7.18). The recurrent volatility in euro area markets is a reminder of how quickly doubts over fiscal solvency can trigger a loss of confidence in financial markets. Government financing needs are expected to stay high in the coming years in view of high fiscal deficits and large maturing debts. The supply of government bonds could increase further in high-income countries once central banks unwind extraordinary monetary policies. Strong growth could make debt problems fade in importance, as investors care about the debt burden relative to GDP. Yet the prospects for a strong rebound are feeble. Even before the latest slowdown in the economic recovery, International Monetary Fund (IMF) growth projections from April 2011 suggested that growth in Europe will decline from before the crisis (figure 7.19). The

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Box 7.10: Improving regional development policies—follow the Irish the end of 2003. In the first two rounds of EU funding, the entire country was classified as an Objective One area. Between 1993 and 2003, cohesion funds supported 120 infrastructure projects at the cost of about €2 billion. The choice of projects was based on a national development plan, which focused on investments in economic infrastructure that stimulated national economic growth. The Irish invested aggressively in education and training and general public services in all of Ireland to create a good business climate countrywide. Today, Ireland is one of the top 10 countries for doing business. Infrastructure Some countries have done better than improvements were more selective. These others in using EU cohesion funds. Box table included investments in leading regions and 1 shows three progressively more successful in connecting leading and lagging areas, such approaches to regional development in Europe, as the M50 (Dublin Ring Road), M1 (Dublinonly a little simplistically called the Italian, Belfast), and improvements in others. With its Iberian, and Irish models. business-friendly policies and good logistics, Ireland has become a popular destination for The experience of Ireland is especially educational. Between 1977 and 2008, Ireland’s American firms and European workers. GDP per capita grew from less than 75 percent Contrast the Irish approach to cohesion funds of the EU average to more than 125 percent. with the “Iberian approach.” Ireland’s rapid Despite the crisis, Ireland remains among convergence toward the incomes of Europe’s the 10 countries with the highest per capita leaders was accompanied by a rising spatial income in the world. What is behind Ireland’s concentration of economic activity. Compared success? Among other things, a sensible with the other cohesion countries—Greece, regional development policy for a small Portugal, and Spain—Ireland’s economic economy. concentration rose much more. But its per capita income grew much faster too. In 1977, Since joining the European Union in 1973, Greece, Ireland, and Spain had per capita Ireland received approximately €17 billion in incomes of about $9,000; Portugal’s was EU Structural and Cohesion Funds through Regional development is again coming to the forefront of debates in the European Union and the Organisation for Economic Co-operation and Development (OECD). This time, these policies are being debated in different economic conditions than before the global economic crisis of 2008–09. OECD economies now face weak growth prospects, with weakened fiscal balances. Regional development efforts will have to contend with more pressing national growth imperatives, and there will be greater pressure to be more frugal with national fiscal resources.

$6,000. By 2002, Portugal had an income of $11,000, and Greece and Spain close to $15,000. Ireland’s per capita income had risen to $27,500. Today, almost all regions in the new member states of the European Union qualify for EU financial support. They should consider using the funds for international convergence and not—until later stages—for spatially balanced economic growth within their borders. European Union candidates—such as the countries of the former Yugoslavia and Turkey—may also be well advised to be singleminded in using the funds for international convergence and not to try to spread economic activity out too soon. As the older member states of Western Europe try to find new drivers of growth and greater efficiency in public spending, they too would do well to shift from an overreliance on placebased interventions to a mix of policies that strengthen social services such as education, health care, and general administration everywhere, combined with selective investments in infrastructure to connect leading and lagging regions. In a few cases, place-based interventions such as special incentives to firms to locate in lagging regions might be necessary. But these should be used least and last, and only along with efforts to improve basic social services and connective infrastructure.

Box table 1: Three approaches to Regional Development in Europe “Italian” Model

“Iberian” Model

“Irish” Model

Rationale

Bring jobs to people

Bring jobs to people and enable them to access product markets

Prepare people to get jobs wherever they are

Objective

Bring economic activity from leading to lagging regions

Facilitate access of producers in lagging regions to markets in leading regions

Integrate lagging and leading regions

Instruments

Emphasize spatially targeted Interventions

Emphasize Interventions and connective Infrastructure

Emphasize Institutions and connective Infrastructure

economic expansion of 2003–08 was fueled by large capital inflows, rapid credit expansion and, in some countries, rising current account deficits and fiscal expansion. By contrast, growth in 2011–16 is set to remain weak, as households and governments reduce their debt, banks deleverage their balance sheets, and investors remain cautious about risks. In Western European countries and their peers, actual output could stay below an economy’s capacity to produce goods and services for years to come, even though the crisis may have lowered

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Figure 7.20: Spending on investment, education, and health was protected during the crisis (public investment (left), and health and education spending (right), percentage of GDP, 2003–08 and 2009/10) Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. Source: World Bank staff calculations, based on Eurostat; OECD National Accounts Statistics; and WDI.

potential output in many countries. Eastern Europe is likely to see the sharpest slowdown. Weak growth in turn implies that tax collection will be sluggish and public expenditure pressures elevated. This will make it difficult to rein in fiscal deficits and decrease public debt. Besides, the population is aging faster. By 2040, there will be only two working-age people for each elderly person in Southern Europe, against five to one in 1980. The ratios are only slightly higher for the other regions in Europe. Population aging tends to dampen growth. Other things being equal, a country with a large share of elderly people and children is likely to grow slower than a country with a large share of working-age people. The link is pretty straightforward: as workers age, they cut back on hours worked or retire. Declining hours and lower labor participation reduce labor supply, which in turn cuts growth. In addition, the skill composition of workers may worsen, as older workers tend to have more obsolete skills than younger workers. This can affect growth even more. Aging not only undermines growth but also makes it hard to improve public finances. Aging is a direct cost driver for public finances, especially for pensions and health. Looking at the G7 countries over 1960–2007, Cottarelli and Schaechter (2010) find that health and pensions accounted for 80 percent of the increase in primary government spending as a share of potential GDP. This reflects population aging, along with other factors such as increases in coverage and generosity of social security plans as well as advances in technology to prolong people’s lives. While the scale of the fiscal challenge is large, a key lesson from the crisis is that it is essential to use the good times to improve fiscal balances. Fiscal policy played a central stabilizing role during the crisis (Blanchard, Dell’Ariccia, and Mauro 2010). Monetary policy had reached its limits through low interest rates and quantitative easing in stimulating the economy. At the same time, the usual concerns about mistiming the fiscal stimulus were less pressing as it became clear early on that the crisis would be long-lasting. Hence fiscal policy became the main policy tool to support domestic demand in some countries, though others could not rely on fiscal policy because they entered the crisis with weak fiscal balances and high public debt. Indeed, some economies ran

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Figure 7.21: Large fiscal adjustments are not unusual (size, percentage of GDP (left), number of large fiscal adjustments (right))

Note: The figure includes fiscal consolidations over at least three years that reduced the cyclicallyadjusted primary balance by 5 percent of GDP or more. Source: Abbas and others 2010.

procyclical fiscal policies driven by consumption booms and had to cut spending and increase taxes in spite of large recessions. The implication is that in order to prepare for the next crisis, many countries have to reduce public debt to below precrisis levels.

Bringing about a sizable fiscal adjustment Governments in Europe have to implement fiscal consolidation strategies that ensure that the economic recovery translates into improved fiscal positions. Most countries have started to implement bold entitlement reforms in response to fiscal pressures, while safeguarding core social spending (Bornhorst and others 2010). An encouraging feature of the fiscal adjustments to date is that countries succeeded in protecting or even increasing outlays for public investments in 2009 and 2010, apart from the south, as well as public education and health spending in 2009 (figure 7.20). In Eastern Europe, access to structural funds or preaccession assistance played a vital stabilizing role, and can be used to improve growth prospects. But their use will have to be rethought; the experience in southern Italy and the original “cohesion countries”—Greece, Ireland, Portugal, and Spain—should be reassessed in deciding how these funds can best be used to foster economic growth and convergence (box 7.10). In 2011, countries envisaged sizable reductions in fiscal deficits and public debt over the coming years. The pace and the structure of the fiscal adjustment vary, reflecting primarily the differences in initial fiscal positions, prospects, and market pressures. Countries with larger fiscal deficits and public debt levels are planning larger fiscal adjustments. Countries facing high unemployment rates tend to plan for less ambitious fiscal adjustment, to limit additional short-term costs that arise from frontloaded fiscal retrenchment. Countries facing higher borrowing costs tend to plan larger adjustments in the near future. For some countries, frontloaded fiscal consolidation can ensure access to markets and the ability to finance deficits at reasonable rates. International experience shows that successful fiscal consolidations share common features (Gray, Lane, and Varoudakis 2007; Clements, Perry and Toro 2010; Blanchard and Cottarelli 2010). First, a fiscal consolidation strategy is crucial to shore up confidence in fiscal sustainability. Indeed, when markets lack

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confidence in the government’s commitment to achieve the needed primary surpluses, a vicious cycle could emerge. Markets could demand higher risk premiums to hold public debt, worsening public debt dynamics further. Second, laying out a clear timeline for fiscal measures can be a way to square the need to shore up sluggish private demand and give public support today with the urgency to inspire confidence in financial markets in sustainable longterm fiscal balances. It might also be easier to phase in structural reform over time, as this allows people and businesses to adjust to the new circumstances. Third, while fiscal consolidation can involve a mix of expenditure and revenue measures (figure 7.21), many countries would need to reduce expenditures. Coming into the recent crisis, many countries had poor structural primary fiscal balances, reflecting the lack of progress in public expenditure reforms, generous spending, and weak public expenditure controls. If well done, fiscal consolidation does not simply make across-the-board cuts. Instead, it focuses on areas where there is little value for money. Entitlement reforms are often part of such structural adjustments, as they are central to strengthening long-term fiscal positions. Indeed, successful fiscal adjustments rely on reducing transfers and wages more than investments in physical and human capital, which are crucial for strengthening an economy’s growth potential (Tsibouris and others 2006). Such measures have to be balanced with the objective of maintaining effective provision of public services to poor and vulnerable families, also because such reforms are more sustainable. Revenue measures can also help to make the fiscal adjustment fairer. Finally, fiscal institutions can make commitments to reducing debt-to-GDP ratios more credible. Medium-term budgetary frameworks, an effective budget process, and independent fiscal agencies that monitor policy design and implementation all make fiscal policy more effective. For example, fiscal rules that limit public expenditure increases during an economic upturn could, with multiyear and performance-based budgeting, contribute to sustainable fiscal finances over the long term. Many EU12 countries have moved in this direction. In addition, the European Council has decided to strengthen economic governance to increase fiscal discipline, broaden economic surveillance, and deepen coordination.

Large adjustments are needed Public debt ratios are a good reference point for establishing longer-term fiscal adjustment needs. We build on the analysis and methodology of the IMF Fiscal Monitors to assess the size of the required adjustment in Europe, along with possible options for reforms in pensions, health, and education. Western Europe and its peers are assumed to reduce debt to 60 percent of GDP by 2030, and Eastern Europe and its peers to 40 percent—for both groups, roughly precrisis levels. The debt threshold is lower for Eastern Europe, as financial markets have lower tolerance levels for public debt in emerging economies; their revenue bases might be more volatile; and public debt is shorter-term, more likely to be held by foreigners, or denominated in foreign currency. The assumption is that countries will meet these targets exclusively through improvements in their primary balances.

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Table 7.1: Illustrative adjustment needs by 2030, median, percentage of GDP IMF projections, 2010

Western Europe

Illustrative fiscal adjustment to achieve debt target in 2030

Gross debt

PB

CAPB

CAPB in 2020–2030

Required adjustment in PB between 2010 and 2020

Required adjustment in CAPB between 2010 and 2020

Required adjustment in CAPB between 2010 and 2020 including pensions

Required adjustment in CAPB between 2010 and 2020 including pensions and health

Required adjustment in CAPB between 2010 and 2020 including pensions, health, and education

73.6

-2.8

-0.6

1.9

4.7

2.5

3.4

6.1

5.8

North

48.4

-2.5

0.0

0.7

3.2

0.7

1.2

4.3

3.6

Center

77.2

-2.2

-0.9

1.9

4.1

2.8

5.4

8.7

8.3

South

101.2

-3.9

-3.1

4.0

7.8

7.0

8.6

11.1

10.9

39.5

-3.3

-2.8

0.4

3.7

3.2

-

-

-

39.7

-4.0

-1.9

0.9

4.9

2.8

2.2

3.7

3.7

Eastern Europe EU12 EU cand.

40.9

-2.9

-2.9

0.5

3.4

3.4

-

-

-

E. prtn.

34.4

-2.6

-2.8

0.3

2.9

3.0

-

-

-

84.0

-4.9

-4.2

0.9

5.8

5.1

6.3

8.4

-

Anglo-Saxon

57.8

-4.9

-4.1

0.7

5.6

4.8

6.2

8.7

-

Japan

220.3

-8.4

-6.7

6.6

15.0

13.3

13.1

14.1

-

42.7

-1.0

-1.1

0.5

1.5

1.6

2.6

3.7

-

Anglo-Saxon peers

Emerging peers

Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. PB and CAPB mean primary balance and cyclically-adjusted primary balance, respectively. The numbers in the last three columns include the fiscal impact of aging in pensions, health, and education. They are missing for EU candidate and eastern partnership countries due to lack of data. Source: Calculations by staff of the Institute for Structural Research in Poland and the World Bank, based on IMF WEO.

A large and sustained improvement in fiscal balances is necessary to bring public debt in Europe to prudent levels. Table 7.1 presents the results: · In Western Europe, the median required improvement in the primary balances is close to 5 percent of GDP. The south faces the largest adjustment (8 percent of GDP). Adjustment needs are lower in Eastern Europe (3.7 percent of GDP), though they are close to 5 percent of GDP for the EU12 countries. · These numbers do not factor in the improvement in the fiscal balances from the recovery. On that basis, the required adjustment goes down to 2.5 percent of GDP for Western Europe and 3.2 percent for Eastern Europe. · Countries have already adopted measures to improve fiscal deficits. Taking into account the fiscal impact of consolidation plans announced by spring 2011 for the next five years, the additional average adjustment need goes down to 0.1 percent of GDP for Western Europe and 0.4 percent for Eastern Europe, net of the impact of trends affecting entitlement spending after 2016 (figure 7.22). Implementing the fiscal adjustment path over the next five years would go a long way to put public finances on a sustainable footing.

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Figure 7.22: Illustrative adjustment needs (median, percentage of GDP)

Figure 7.23: Illustrative adjustment needs and projected increase in health and pension expenditures (median, percentage of GDP)

Note: “EU cand.” refers to EU candidate countries and “E. prtn.” refers to EU eastern partnership countries. CAPB means cyclically-adjusted primary balance. Source: Calculations by staff of the Institute for Structural Research in Poland and the World Bank, based on IMF WEO.

Box 7.11: Changes in behavior and policies enable countries to adjust to aging Pessimism about Europe’s ability to meet economic challenges in the light of population aging may be unwarranted. One reason this concern may be misplaced is that the rise in life expectancy is not foremost an economic problem but a boon to people’s well-being. Also, age accounting, while useful as a benchmark, is also likely to overstate the impact of aging on growth and fiscal outcomes for two reasons: people change their behavior, and policymakers change policies. As people

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age, they are likely to work in later years. A rise in healthy life expectancy enables people to work productively for more years, without reducing the number of years in retirement. In addition, as people realize they might live longer, they tend to increase their savings at working ages to fund consumption in old age. The reduced fertility that adds to the shift toward older populations also means that more women can enter the labor force. Policy

is crucial to support these changes in behavior. In particular, there should be no incentives for early retirement, as in an extreme form of a mandatory retirement age. Other measures include flexible old-age pension arrangements, legal efforts to ensure that employers do not discriminate against older workers, lifelong learning programs, investments in old-age health, and policies encouraging migration. Source: Bloom, Canning, and Fink 2008.


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Figure 7.24: Pensions are more generous in Western Europe than elsewhere (real public pensions per elderly person, thousand US$ PPP, 1980, 1994, and 2007)

Source: World Bank Social Protection database.

· Adjustment needs increase with population aging. Assuming unchanged policies, expenditures on health and pensions are likely to increase the needed fiscal adjustment by close to 3.6 percent of GDP in Western Europe and 0.9 percent in the EU12 (figure 7.23). Public spending on health care alone is expected to contribute most to the spending increases. In Western Europe and the EU12, almost three-quarters of the increase in age-related spending is due to health expenditures. Overall, accounting for the fiscal costs of aging in health, pensions, and education, the required adjustment in 2010–20 increases to 6 percent of GDP for Western Europe and 3.7 percent of GDP for the EU12. Structural reforms are necessary to deal with the long-term fiscal challenges in Europe arising from precrisis weaknesses, the debt overhang from the crisis, and pressures from population aging. They are also needed to reinvigorate growth. Higher growth can help countries reduce the size of required fiscal adjustment. For example, our simulations suggest that boosting growth by 1 percentage point throughout 2011–30 would lower the required correction in cyclically adjusted primary balances by 0.6 percent of GDP in Western Europe and 0.4 percent in Eastern Europe. As the population adjusts to the tough economic reality, aided by the right policies, Europe might find out that the adjustment is easier to make than now imagined (box 7.11).

Reforming public pensions Large spending on pensions is the main reason why governments are bigger in Europe than elsewhere. Public pensions are high relative to those in AngloSaxon countries and Japan (figure 7.24). This holds especially for the center, but also for the north and the south. Similarly, gross pension replacement rates are high in Europe (see figure 1.14 in chapter 1). High public spending on pensions, combined with moderate spending on education and health, suggests that governments favor the elderly over the young and working-age generation, desiring long-term growth prospects. This indicates that there is room for further savings on public pensions, especially as private pensions become more important in providing incomes to the elderly. European OECD countries have succeeded in reducing pension generosity in response to population aging

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Box 7.12: Reversal of private pension pillars Many countries in Eastern Europe have overhauled their pension systems during the last 15 years. Fourteen countries introduced a second private pillar to complement the first (mandatory unfunded) pillar. The second pillar is typically mandatory (workers are required to participate), funded (pensions are paid from a fund accumulated from contributions), and with defined contributions (pension benefits are determined by the assets accumulated for a person’s pension). Countries often combine the first and second pillars with a third, voluntary privately funded pillar. In response to the crisis, however, several countries reduced funding for the second pillar (box table 1). Countries backtracked on reforms for three reasons. First, the crisis has underlined the importance of making sure that first-pillar benefits can be financed. Contributions to the first pillar have taken a hit with lower wages and higher unemployment. For example, while the first pillar was originally targeted to run a surplus from 2012, Poland feared the first pillar might remain in deficit until 2060. At the same time, it has become harder for government to be a backstop for deficits in pension systems. Second, the introduction of second pillar pensions makes it more difficult for countries to comply with the EU Stability and Growth Pact. To support the buildup of second pillar funds, governments run higher fiscal deficits and accumulate more public debt during the transition phase. While this comes at the benefit of improved long-term fiscal balances, the Stability and Growth Pact’s fiscal deficit and public debt criteria do not take this into account sufficiently. In addition, financial markets worry more about explicit than implicit debt.

Third, while the reforms might take more time to bear fruits because as the size of second pillars is in many countries still modest, the second pillar systems have not always performed as hoped. Private pillars generated decent rates of return before the crisis. Countries with second pillar pension systems also tend to look better in terms of long-term sustainability, though this mostly reflects that they were more active in lowering pension benefits under the first pillar. Yet, it is clear that expectations proved too optimistic. Governments have had to subsidize the buildup of funds for the second pillar more than expected.

consider some lessons of the recent reforms: • Abrupt changes lead to instability and can undermine the credibility of pension systems and the trust in government. • The fiscal effects of reversals are often negligible, as they trade off improvements in the short run with deteriorations in the long run in headline fiscal balances.

• The reversal of second pillar regimes should be no excuse to delay addressing structural problems, whether in the area of pensions or elsewhere. Many countries should raise the retirement age, rationalize special schemes and disability benefits, move from wage- to inflation-indexation of pension Poland’s finances illustrate these points. Due to benefits, and improve the regulation of the crisis, the fiscal cost rose to 1.5 to 2 percent private pension funds. of GDP in 2000–10 instead of the predicted 0 to 1 percent of GDP. The transition costs have • Countries like Chile and Sweden have turned out to be higher in part because of managed to get benefits from second worse than anticipated trends in the economy pillar pensions. Countries in Eastern Europe (weaker growth), demography (sharper drop considering second pillars should think in fertility, larger emigration), and labor market carefully whether they will be able to (lower rise in formal employment). In addition, replicate these successes. This involves individuals have responded less well to looking at economic, distributional, incentives to increase savings for old age than and institutional aspects. Institutional expected. Private savings have been almost prerequisites include a sustainable first pillar entirely offset by public dissaving. The public system, sound macroeconomic policies, support of the second pillars was financed adequate supervision and regulation of the through public debt issues of about 15 percent financial sector, administrative capacity of GDP, while private pension assets amounted to manage individual accounts, and the to about 16 percent of GDP by end-2010. political institutions to prevent undue Many countries in Eastern Europe are set to make further adjustments in their pension systems. Most countries require further adjustments to their first pillar regimes; others are considering reversing or modifying their second pillar regimes; still others are considering introducing new second pillar systems. All of them would be well advised to

political interference with the second pillar over generations.

Source: Barr 2010; Barr and Diamond 2008; OECD 2011b; Soto, Clements, and Eich 2011; Velculescu 2011; World Bank 2010a.

Box table 1: Recent measures to reduce contributions to the second pillar Country

394

Measure

Estonia

Temporary suspension of contribution (4 percent)

Hungary

Permanent diversion of contribution to first pillar; second pillar changed from mandatory to voluntary

Latvia

Temporary reduction of contribution from 10 percent to 2 percent

Lithuania

Temporary reduction of contribution from 5.5 percent to 2 percent

Poland

Reduction of contribution from 7.3 percent to 2.3 percent from May 2011; increase to 3.5 percent by 2017


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Source: World Bank Social Protection database.

since the early 1990s, even though the elderly are a political force. And many countries in the EU12 have adopted pension reforms to mitigate the impact of aging on public finances (box 7.12).

Figure 7.25: Social insurance contribution rates in Europe are often high

As pension systems become more and more unsustainable, some governments show a propensity to push certain entitlements in the (noncontributory) social assistance area, while preserving eligibility and benefit formulas. For example, when the pension system went into deficit in 2005 in Romania, entitlements financed from social security contributions, such as farmers’ pensions and paid parental leave, were shifted to the general budget and are now tax-financed. These moves only created the illusion of restoring fiscal sustainability of the pension system. They also maintained a regressive benefit (parental leave) that paid high benefits for long periods to middle- and high-income parents, keeping them out of the labor market for about two years, while denying such benefits to parents from low-income households. When former pension benefits have to be shed, governments are well advised to design them using the objectives for good safety net programs, including restricting them to the most needy.

(contribution rates of pensions and social insurance, percentage of gross earnings, latest data)

Increasing longevity and lower fertility put increasing pressure on pension systems. Following the European Commission methodology, without policy change, pension expenditures would increase by 1.1 percent of GDP by 2030 in Western Europe, and decline by 0.3 percent of GDP in the EU12. In Western Europe, the challenge is largest in the center but moderate in the north. The required savings are not huge. For example, the pension reforms introduced in Finland, Germany, Italy, Spain, and Sweden in 1995–2005 should reduce public pension expenditures by more than 2 percent of GDP by 2030 (Clements, Perry, and Toro 2010). As people get older, pension benefits cannot simply keep up with workers’ incomes. These pressures are visible in both public and private pension plans, where actuarial changes are making systems less generous. Whatever the system, prolonging the retirement phase means that for a given return on savings, retirement benefits have to shrink relative to wages earned during the

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Figure 7.26: Raising the retirement age helps stabilize pension spending (projected increase in pension expenditures and impact of pension reforms, medians, percentage of GDP)

Source: Calculations by staff of the Institute for Structural Research in Poland and the World Bank.

working life. Making the pension system more sustainable involves moderating the increase in the ratio of retirement to working life or moderating the ratio of pension benefits relative to wages (or a combination). As pension contributions in Europe are already high, the second option mainly involves reducing the generosity of pension benefits (figure 7.25). Encouraging people to work longer would involve a combination of raising the statutory retirement age, penalizing early retirement, and removing legal or other impediments for people age 50 or older to get a job. Changes in indexation formulas from a combination of wage growth and inflation to inflation only is one way to adjust pension benefits, especially for countries in Eastern Europe. Such reforms have been implemented in Japan, the Republic of Korea, and Sweden; others should consider them too. Alternatively, countries can focus public pension systems on the low-income elderly. Canada, the Netherlands, and New Zealand combine low public pension spending with low old-age poverty because their public pension systems are relatively redistributive. This approach can work well when countries succeed in encouraging people to compensate for lower public pensions with higher savings through private pensions (OECD 2011b). As an illustration, one can look at the impact of raising the effective retirement age (for example, increasing the employment rate among those of working age) and increasing the statutory retirement age (for example, increasing the employment rate of the elderly) by 5 percent (figure 7.25). For the EU12, this is equivalent to increases of three years in the effective and statutory retirement ages, resulting in longer working lives by six years. Of course, increases in the statutory retirement age do not lead to one-to-one increases in working lives. Instead, governments have to work on measures on both the supply side (strengthening incentives to work) and demand side (ensuring that there are jobs for the elderly) to make this happen. These reforms would keep public pension expenditures at 2010’s level in Western Europe. The EU12 countries would reduce outlays for public pensions from more than 8 percent of GDP in 2010 to less than 7 percent in 2030. Such reforms would also be good for economic recovery. As people’s future income increases, they are likely to scale up today’s consumption (figure 7.26).

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Reforming public health Europe’s public health spending is still moderate and most health outcomes are impressive. While some countries in Eastern Europe are struggling to overcome the challenges of the past—including heavy hospital infrastructure, overreliance on inpatient and specialized care, and neglect of preventive care—the problems of public health systems lie foremost in the future. Health care expenditures around the world tend to rise faster than incomes, and Europe, where median public health spending increased from 5.2 percent of GDP in 1995 to 6.4 percent in 2009 (figure 7.27), is no exception.

Figure 7.27: Public health spending has increased faster than GDP (public health spending in Europe, percentage of GDP, 1995 and 2009)

Source: Eurostat; and OECD Social Expenditure Database.

Box 7.13: Long-term care policies for older populations in new member states and Croatia The new EU member states and Croatia are facing rapidly aging populations. In 2025, more than 20 percent of Bulgarians will be age 65 or older, up from just 13 percent in 1990, and the average Slovene will be 47 years old, among the oldest in the world. One consequence of these demographic changes is the expected increase in demand among the older population for long-term care (LTC). LTC services refer to the organization and delivery of a broad range of services and assistance to people who are limited in their ability to live independently over an extended period. Experience from Organisation for Economic Co-operation and Development (OECD) countries shows that LTC is expensive and generates a financial burden for individuals and households. Much financial uncertainty surrounds future LTC expenditures, and private LTC insurance systems are underdeveloped. Increasing good practice in OECD countries means promoting a policy of universal

coverage. Yet if countries are to adopt such policies—given the growing size of the older population and growing dependency ratios— they must closely examine the policies’ fiscal sustainability. Thus the key policy challenge facing new EU member states and Croatia is how to balance the twin objectives of fair financing (where those in need can afford LTC) with fiscal sustainability. Governments can meet this challenge in four ways: • Develop a policy for universal LTC financing based on the concept of intergenerational fiscal sustainability. Use actuarial and other financial models to cost out the revenue and expenditure implications of expanding universal LTC coverage. Identify the appropriate package and identify the role of supplementary LTC coverage through other instruments.

• Do not expand LTC coverage on an inefficient base but use LTC financing to control demand for services and channel it toward the right types of services (homebased with care coordinaton and conversion of hospitals into community centers and not LTC institutions). • Think about how to leverage LTC servicedelivery reforms and encourage private provision. (This depends heavily on LTC financing policies and the overall regulatory environment.) • Develop a strong evidence base on LTC financing and provision. As part of developing an LTC policy, begin monitoring LTC expenditures to learn whether they pose a burden on households or how households are coping with them during old age. Build a database on coverage of LTC services and trends over time. Source: World Bank 2010b.

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Figure 7.28: Young cohorts are shrinking in Eastern Europe (population ages 5–24, 1980–2100, 2010 = 100)

Source: UN 2011.

Based on historical trends, unit costs of health treatment grow 1 percentage point faster than GDP per capita. This leads to increases in public health spending of 2.7 percent of GDP in Western Europe and 1.5 percent in the EU12 by 2030. Further costs pressures could arise from faster technology adoption and imitation. For the EU12, this could imply that public health spending increases by as much as 3.5 percent of GDP by 2030. The challenge is how to manage the pressures that lead to escalating costs and expenditures without undermining many countries’ generally sound health-system performance. After all, reducing public health spending in a bad way can ultimately undermine important health policy goals or simply defer spending. Governments are striving to control cost escalation while preserving the public sector’s crucial role in providing good health care. One major pressure point is spending on long-term care services (box 7.13). A recent IMF cross-country analysis concluded that international experience offers various options to control the growth of public health spending (Clements, Perry, and Toro 2010). They include pushing through with provider payment reforms using case-based payment or global budgets rather than fee for service, strengthening evaluations of the cost-effectiveness of medical treatments and technology, implementing health information technology to increase the efficiency of service delivery, and increasing patient cost-sharing to encourage patients to go to the doctor only when needed. At the same time, the most sustainable way to control health spending over the decades is to ensure value for money, though sometimes this might mean investing more upfront (OECD 2010).

Reforming public education Population aging puts upward pressures on the costs of public pensions and public health, but also provides an opportunity for fiscal saving in education. The population age 5–24 years changes little in 2010–30 in Western Europe but

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is set to decline by about 15 percent in Eastern Europe (figure 7.28), where many countries maintain too many schools, and are failing to consolidate schools and reduce teaching staff in line with shrinking student numbers. Other problems are Europe-wide, including disappointing learning achievements in international assessments for some countries and minority groups, graduation of pupils and students without the skills needed by industry and other employers, little lifelong learning, and poor information on learning outcomes. Supporting education and training systems that serve the needs of the economy is one of the important roles of a high-quality government. Some European countries start focusing on technical skills too early in a student’s career, leaving graduates ready for their first job but possibly without enough generic skills to be retrained into a different field later. Other European countries now have sophisticated adult education and training systems in place; others have barely started. With aging populations, it is essential to have options, incentives (for workers and firms), and quality assurance mechanisms; and these systems cannot be built overnight. Following the methodology of the European Commission, we project public expenditures on education to change little in 2030 relative to 2010. Median expenditures on education would decline by 0.3 percent of GDP in Western Europe, and remain unchanged in the EU12 countries. Adjusting the number of education personnel in line with the changes in the number of students would generate sizable fiscal gains. Education spending would decrease by 1.1 percent of GDP in the EU12 countries, 0.7 percent in the south, 0.3 percent in the north, and 0.1 percent in the center.5 Such saving could either be used to invest in education quality, or pay off public debt and reduce the size of government.

Make government more efficient, or make it smaller Governments in Europe generate plenty of reasons to worry. When big, they hamper growth. The crisis has made governments even bigger, and countries are struggling to reassure nervous financial markets in the face of large fiscal imbalances and rising public debt. These concerns are weighing on growth. The recovery has relied on public support and the global upturn rather than domestic investment and FDI. Population aging further dampens the outlook, as labor gets scarcer and demand for public services stronger. Reform is an unrelenting task for all governments, but some governments need more—and more urgent—reforms than others. The south does poorly on key dimensions compared with the rest of Western Europe and, increasingly, with countries in Eastern Europe: · Although the south still has somewhat smaller government than the center and the north, government size has been increasing in the south over the last decade and a half. Efforts to consolidate government spending weakened in Europe during the boom years before the global financial crisis in 2008-09. But spending on pensions and social transfers rose far more in the south than in the rest of Western Europe. The south spends more than the north or center when taxes are factored in on the social sector as a share of GDP.

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· Europe has been an economic convergence machine, helping poorer countries to catch up to richer economies. Yet even though the forces of convergence should have translated into faster growth in the south, growth in the south has been slower than in the north and the center over the last decade and a half. One reason for the south’s poor growth is that quality of government is worse than elsewhere. The south has fallen further behind the north and the center in quality of government, even though its public sector wage bills expanded. · Oversized government, moderate growth, weak institutions, and a rapidly aging population give rise to large fiscal imbalances. And it is the south that faces the largest fiscal adjustment in coming decades. For Eastern Europe, the differences across countries are less striking than for Western Europe. Nevertheless, taking the EU candidate countries as an example, the need for substantial reform is evident: · Although the EU candidate countries are poorer than the EU12 countries, their government size (measured as government spending as a share of GDP) is about the same. Size declined in the EU12 from the mid-1990s to the late 2000s, but increased in the candidate countries. Spending on pensions, health, and education as a share of GDP is higher in the candidate countries than in the EU12 and eastern partnership countries. · The candidate countries have seen less convergence in living standards than the rest of Eastern Europe, even though they are poorer than the EU12 countries. One reason is that many of the candidate countries have benefited less from trade integration since the late 1990s than the EU12 countries. The other reason, more pertinent for this chapter, is that candidate countries lag the new member states of the EU in quality of government, and the gap has been widening over the last decade. · Candidate countries have weaker fiscal balances than EU12 or eastern partnership countries, and face a larger longer-term fiscal adjustment to stabilize public debt. Such an array of difficulties makes it easy to give in to pessimism. But there are also good reasons to be optimistic. First, Europe has repeatedly shown a capacity to reform. The list of countries that have succeeded in bringing about large improvements in their fiscal balances since the 1980s is long, though the advances have not always been sustained.6 But soon we might be able to talk about sustained fiscal consolidation in countries like Estonia, Ireland, or Latvia. Indeed, public finance reform might be easier today than in the past, largely because the crisis has convinced more people of its urgency, even if some countries’ large public debt originates in the private sector. Many countries are lowering public benefits, reducing salaries, and increasing working hours. Countries like France, Greece, Italy, Portugal, Spain, and the United Kingdom have recently adopted fiscal reforms whose scope and size might have been unthinkable just a few years ago.

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Second, to ensure prosperity and well-being, well-run governments can make an enormous difference. With public sectors accounting for half of domestic output, making sure that government works better can help spur productivity and innovation in the economy. Absorbing lessons from other countries about what works (and what does not), countries can make the bureaucracy leaner, fiscal institutions more reliable, public services more competitive, tax administration more effective, and citizens more informed through electronic government. Third, Europe has demonstrated that it can adjust public finances to population aging. In Western Europe, many countries have altered pension parameters to put a lid on public pension spending as elderly cohorts started to grow. In Eastern Europe, countries such as Estonia, Poland, and the Slovak Republic revamped their pension programs so that they have sound system finances. As pensions remain fairly generous in Europe, many countries still have room to advance pension reforms as population aging accelerates. Countries also need to address education and health with equal urgency. Cost escalation in health care—driven by increased demand from rising incomes and by new, high technology–related health procedures—is the main risk to fiscal sustainability. Countries in Eastern Europe can learn from their neighbors to the west about how to adjust spending on teachers in line with demographic trends. Fourth, beyond putting public finances in order, Europe can do much to improve trade, finance, enterprises, innovation, and labor. Lifting growth even a little over the coming decade can cut the size of the required fiscal adjustments. Faster growth increases tax revenues and can also lower government spending on social programs as earnings increase, on unemployment benefits as jobs become more plentiful, and on servicing public debt as markets charge lower interest on government bonds. A well-run welfare state can help make this happen—its safety net allows people to take risks and invest in their business ideas without worrying about their families’ health insurance or children’s education if plans go awry. There is no one “best” government form and size. Some societies care more about strong growth, others more about inclusive growth. Countries have diverse institutions, histories, and politics, which make governments different in more ways than size. Each country has to decide what type of government it wants and how it wants to reform what it has. Northern Europe outperforms much of the rest of Europe on many fronts, including growth, public services, equity, and quality of government. Northern Europeans have found that these benefits come with big government but with many individual responsibilities: they have higher labor force participation rates, they stay engaged in the formal economy despite having to pay high taxes, they have enabled women to combine work and family, they have provided enterprises with the economic freedom needed to compete globally—undertaking sweeping economic reforms when necessary—and they maintain high levels of social trust.

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Doing all this is not easy. It might be more feasible for most countries to keep government small until the institutional and social prerequisites of “big government lite” are put in place. All the countries in Southern Europe, many in Eastern Europe, and even some in Western Europe should keep the main point of this chapter in mind: without high quality of public services and social programs, big government will be a heavy burden and become a drag on economic growth. With poor economic growth prospects, even reasonably sized governments inevitably become an unbearable burden.

Answers to questions on page 353

Governments in Europe spend about 10 percent of GDP more than their peers, and this is almost entirely because they spend more on social protection. Controlling for other differences, European economies with government spending greater than 40 percent of GDP have had much lower growth rates during the last 15 years. Countries like Sweden have big governments, but they deliver high-quality social services, make it easy for citizens and enterprises to comply with taxes and regulations, and have high levels of social trust. Countries where government works have made their bureaucracies leaner, fiscal institutions more reliable, public services competitive, tax administration effective, and citizens more empowered. To respond to market pressures and aging populations, almost every country in Europe must make big fiscal adjustments to reduce public debt to precrisis levels. 402


CHAPTER 7

Chapter 7: Annexes Table A7.1: Political institutions inďŹ&#x201A;uence government size (OLS regression results on the logarithm of government size, 1995â&#x20AC;&#x201C;2009) Variables

(1)

(2)

(3)

Log per capita GDP PPP

(4) .27 (8.9)

Log public debt (percentage of GDP)

.10 (10.8)

.08 (9.4)

.08 (8.3)

Log trade openness (percentage of GDP)

-.08 (5.4)

-.05 (4.0)

-.05 (3.6)

Log old-age dependency ratio

.09 (1.4)

.12 (1.9)

Log unemployment rate

.10 (9.0)

.09 (8.1)

Fractionalization

.06 (2.5)

Federalism

.04 (2.7)

Electoral system

-.07 (4.2)

Bicameralism

.01 (0.9)

Constitutional design

-.06 (2.8)

Western Europe Center

-.09 (2.0)

-.07 (2.5)

-.09 (3.5)

-.10 (3.3)

South

-0.12 (2.3)

-0.18 (5.7)

-0.21 (6.8)

-0.19 (5.8)

-0.20 (4.8)

-0.07 (2.6)

-0.10 (3.5)

-0.07 (2.3)

Eastern Europe EU12 Accession

-0.27 (5.9)

-0.15 (4.7)

-0.24 (6.6)

-0.23 (6.2)

Eastern partnerships

-0.67 (14.2)

-0.19 (4.7)

-0.11 (2.6)

-0.11 (0.2)

Anglo-Saxon and Japan

-0.27 (5.8)

-0.33 (10.8)

-0.32 (11.0)

-0.25 (7.1)

Emerging peers

-0.65 (17.2)

-0.57 (20.9)

-0.56 (20.9)

-0.48 (14.1)

3.9 (76.7)

3.27 (37.4)

2.1 (7.1)

2.1 (7.1)

Yes

Yes

Yes

Yes

R squared

0.42

0.68

0.71

0.73

Number of observations

1,023

833

808

800

Constant Year controls

Note: Western Europe North is omitted. t-statistics in parentheses. OLS refers to ordinary least squares. Source: World Bank staff calculations.

403


GOLDEN GROWTH

Table A7.2: Regression Results for Growth and Initial Government Expenditures, 1995 to 2010 Variables

(1) OLS

1. World 1995 to 2010 Government size -0.0003 Real per capita income -0.0000** Number of observations 152 Adjusted R squared 0.0123 Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) 2. World 1995 to 2006 Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) 3. World 1995 to 2006 and government size more than 40 percent of GDP Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) 4. World 1995 to 2006 and government size less than or equal to 40 percent of GDP Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) 5. Europe 1995 to 2010 Government size -0.0016*** Real per capita income -0.0000** Number of observations 42 Adjusted R squared 0.3978 Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) 6. Europe 1995 to 2006 Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) 7. Europe 1995 to 2006 and government size more than 40 percent of GDP Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) 8. Europe 1995 to 2006 and government size less than or equal to 40 percent of GDP Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value)

(2) OLS

(3) Pooled OLS

(4) Robust regression

-0.0003 -0.0000*** 106 0.2703

-0.0001 -0.0000*** 399 0.2095

0.0001 -0.0000*** 399 0.2337

-0.0001 -0.0000*** 301 0.1992

0.0002 -0.0000*** 301 0.2199

-0.0009* -0.0000*** 78 0.3476

-0.0005 -0.0000*** 76 0.4163

0.0001 -0.0000*** 223 0.1968

0.0004 -0.0000*** 223 0.1797

-0.0007** -0.0000*** 124 0.5350

-0.0004* -0.0000*** 124 0.6023

-0.0010* -0.0000*** 91 0.3955

-0.0004 -0.0000*** 91 0.5176

-0.0014** -0.0000*** 66 0.3586

-0.0011** -0.0000*** 65 0.4698

0.0022 0.0000 25 0.5438

0.0028* 0.0000 25 0.5750

-0.0009** -0.0000*** 33 0.6701

***, **, and * denote significance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: The rows government size and real per capita income show parameter estimates except for the last column. Standard errors are heteroskedasticity and countryspecific autocorrelation consistent. Except for (1), the regressions also include these additional right-hand side variables: years of schooling, inflation, trade openness, old-age dependency ratio, terms of trade growth, quality of regulation, and rule of law. All regressors are initial values. Regressions (1) and (2) are cross-sectional regressions. Regressions (3) to (8) are four-year period panels. Regressions (3), (4), (6), (7), and (8) also include time-fixed effects. The null hypothesis of the Arellano-

404


CHAPTER 7

(8) BACE, BE

(5) BE

(6) FE

(7) SGMM

Coefficient

Including probability

-0.0003 -0.0000*** 399 0.2039

-0.0003 -0.0000*** 399 0.3120

0.0011** -0.0000* 399

-0.0005 -0.000001 399

0.2822 0.2067

-0.0001 -0.0000*** 301 0.1971

-0.0004 -0.0000* 301 0.2695

0.0013 -0.0000** 301

-0.0002 -0.000001 301

0.0000 0.9997

-0.0013* -0.0000*** 78 0.4335

-0.0012 -0.0000** 78 0.2221

-0.0017* -0.0000** 78

-0.0015 -0.000002 78

0.0000 0.9959

0.0003 -0.0000*** 223 0.1798

-0.0003 0.0000 223 0.2238

0.0004 -0.0000* 223

-0.0001 -0.000001 223

0.0319 0.9659

-0.0004 -0.0000* 124 0.3235

-0.0006 -0.0000** 124 0.5876

-0.0017** -0.0000* 124

-0.0006 -0.000001 124

1.0000 0.9455

-0.0008* -0.0000** 91 0.5761

-0.0002 -0.000001 91 0.5640

-0.0006 -0.000001 91

-0.0009 -0.000001 91

0.9996 0.9994

-0.0023** -0.0000*** 66 0.5015

-0.0006 -0.000001 66 0.3305

-0.0010 -0.000001 66

-0.0022 -0.000002 66

0.9408 0.9882

0.0000 0.0000 25 0.7984

0.0001 -0.0000* 25 0.8906

0.0071 0.0000 25

-0.0005 0.0966 25

0.0000 0.9598

0.0550 0.0740

0.4920 0.4970

0.5360 0.6000

0.3080 0.4030

0.5090 0.8700

0.4420 0.1890

0.7980 0.2970

0.5360 0.9900

Bond AR(2) test is that the ďŹ rst-differenced errors exhibit no second-order serial correlation. The null hypothesis of the Hansen J-statistics is that the instruments are not correlated with the residuals. The prior mean model size in the BACE regressions is 3. For the estimation methods, OLS, BE, FE, SGMM, and BACE refer to ordinary least squares, between effects, ďŹ xed effects, system GMM (generalized method of moments), and Bayesian averaging of classical estimates, respectively. Source: World Bank staff calculations.

405


GOLDEN GROWTH

Table A7.3: Regression results for growth and initial government revenues in Europe, 1995–2010 Variables Europe 1995 to 2010 Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) Europe 1995 to 2006 Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value)

(1) OLS

(2) OLS

(3) Pooled OLS

(4) Robust regression

-0.0003 -0.0000** 42 0.2944

-0.0005 -0.0000** 33 0.6253

-0.0007 -0.0000*** 124 0.5363

-0.0001 -0.0000** 124 0.6033

-0.0009 -0.0000*** 91 0.4109

-0.0001 -0.0000*** 91 0.5259

Table A7.4: Regression results for growth and initial social transfer spending in Europe, 1995–2010 Variables Europe 1995 to 2010 Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) Europe 1995 to 2006 Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value)

(1) OLS

(2) OLS

(3) Pooled OLS

(4) Robust regression

-0.0023 -0.0000** 42 0.3307

-0.0003 -0.0000* 33 0.6017

-0.0011** -0.0000*** 127 0.5487

-0.0005 -0.0000** 127 0.5934

-0.0023 -0.0000** 42 0.3307

-0.0003 -0.0000* 33 0.6017

-0.0017** -0.0000*** 94 0.4497

-0.0008** -0.0000*** 94 0.5262

Table A7.5: Regression results for growth and average public investment spending in Europe, 1995–2010 Variables Europe 1995 to 2010 Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value) Europe 1995 to 2006 Government size Real per capita income Number of observations Adjusted R squared Arellano-Bond AR(2) test (p value) Hansen J-statistics (p value)

(1) OLS

(2) OLS

(3) Pooled OLS

(4) Robust regression

0.0101** -0.0000*** 42 0.4341

0.0033 -0.0000* 33 0.6170

0.0011 -0.0000** 126 0.5646

0.0009 -0.0000** 126 0.5901

0.0101** -0.0000*** 42 0.4341

0.0033 -0.0000* 33 0.617

0.0035 -0.0000** 93 0.4494

0.0036** -0.0000*** 93 0.5268

***, **, and * denote significance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: See note for table A7.2. Source: World Bank staff calculations.

406


CHAPTER 7

(8) BACE, BE

(5) BE

(6) FE

(7) SGMM

Coefficient

Including probability

-0.0008* -0.0000* 124 0.4210

-0.0003 -0.0000** 124 0.6011

-0.0023** 0.00000 124

-0.0009 -0.000001 124

0.9979 0.9933

-0.0010** -0.0000** 91 0.6132

0.0002 -0.000001 91 0.5775

-0.0008 -0.000001 91

-0.0008 -0.000001 91

0.0272 0.9588

(5) BE

(6) FE

(7) SGMM

-0.0007 -.00000 127 0.3425

-0.0022 -0.0000** 127 0.5900

-0.0029** -.00000 127

-0.0012 -0.0000** 94 0.5012

-0.0039 0.000000 94 0.4585

-0.0044 0.000000 94

(5) BE

(6) FE

(7) SGMM

0.0010 -0.0000 126 0.4185

-0.0016 -0.0000** 126 0.6007

-0.0069 -0.0000 126

0.0017 -0.0000 93 0.5072

0.0109*** -0.0000** 93 0.5215

-0.0139 -0.0000** 93

0.63 0.46

0.221 0.206

(8) BACE, BE Coefficient

Including probability

-0.0010 -0.0000007

0.9982 0.6956

-0.0017 -0.000001

1.0000 0.7850

0.215 0.621

0.674 0.577

(8) BACE, BE Coefficient

Including probability

0.0023 -0.0000006

0.9998 0.8710

0.0007 -0.000001

0.2223 0.8522

0.452 0.597

0.836 0.859

***, **, and * denote signiďŹ cance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: See note for table A7.2. Source: World Bank staff calculations.

407


GOLDEN GROWTH

Table A7.6: Regression results of quality of government on initial government size (1) World

(2) Europe

(3) World

(4) Europe

(5) World

(6) Europe

1. Enabler of private sector Indicator Source

Rule of law

Regulation

Indep. judiciary

WB Governance

WB Governance

Henisz Polcon

Bivariate regression Coefficient Robust t-statistics

0.05

0.06

0.04

0.05

0.02

0.02

7.80***

7.42***

5.67***

5.46***

6.44***

4.26***

Number of observations

167

43

166

43

160

42

Adjusted R square

0.34

0.38

0.25

0.38

0.21

0.25

Multivariate regression Coefficient Robust t-statistics

0.03

0.03

0.02

0.02

0.01

0.02

4.20***

2.57**

2.51**

1.85*

3.05***

1.73*

Number of observations

155

41

155

41

151

40

Adjusted R square

0.56

0.79

0.44

0.61

0.35

0.24

2. Enabler of economic globilization Indicator Source

Free trade

Econ. globilization

Tariff rate

Fraser Institute

KOF Index

Fraser Institute

Bivariate regression Coefficient

0.96

0.63

0.04

0.04

-0.16

0.01

8.39***

3.78***

4.46***

2.90***

5.03***

0.31

Number of observations

133

41

120

34

138

42

Adjusted R square

0.34

0.25

0.15

0.15

0.12

-0.02

Robust t-statistics

Multivariate regression Coefficient

0.59

0.29

0.03

0.04

-0.12

0.02

3.32***

1.45

2.16**

1.62

2.18**

0.36

Number of observations

128

39

115

34

131

40

Adjusted R square

0.41

0.37

0.15

0.31

0.2

-0.08

Robust t-statistics

3. Efficient administrator Indicator

Gov. effectiveness

Control of corrupt.

Formal economy

WB Governance

WB Governance

Schneider

Source Bivariate regression Coefficient Robust t-statistics

0.05

0.06

0.05

0.07

0.52

0.88

7.05***

6.19***

8.37***

6.54***

6.50***

5.79***

Number of observations

167

43

166

43

145

40

Adjusted R square

0.31

0.36

0.35

0.35

0.23

0.47

Multivariate regression Coefficient Robust t-statistics

0.03

0.02

0.03

0.02

0.35

0.46

3.64***

1.79*

4.74***

2.73***

3.48***

3.27***

Number of observations

155

41

155

41

141

40

Adjusted R square

0.53

0.76

0.55

0.82

0.36

0.73

4. Enabler of voice and accountability Indicator

Instit. democracy

Voice and account.

Political stability

Polity IV

WB Governance

WB Governance

Source Bivariate regression Coefficient Robust t-statistics

0.11

0.17

0.04

0.06

0.04

0.04

4.06***

3.69***

5.37***

6.43***

7.28***

4.64***

Number of observations

155

39

167

43

167

43

Adjusted R square

0.11

0.52

0.22

0.53

0.28

0.31

Multivariate regression Coefficient Robust t-statistics

0.08

0.17

0.02

0.04

0.03

0.02

2.03**

3.16***

2.48**

3.09***

4.18***

2.27**

Number of observations

146

37

155

41

155

41

Adjusted R square

0.2

0.51

0.38

0.69

0.33

0.51

***, **, and * denote signiďŹ cance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: The quality of government indicators are 2003â&#x20AC;&#x201C;08/9 averages. Higher values indicate higher quality of government. The multivariate regressions also include these additional right-hand side variables: 1995 to 2002 average per capita income and the time-invariant variables ethno-linguistic fragmentation, French legal origin, socialist legal origin, and distance to Brussels.

408


CHAPTER 7

(7) World

(8) Europe

(9) World

(10) Europe

(11) World

(12) Europe

(13) World

(14) Europe

Dismissal cost

Centr. collect. bar.

Tax compl. cost

Top mar. tax rate

WB Doing Bus.

Glob. Compet. Rep.

WB Doing Bus.

Fraser Institute

0.08

0.02

-0.03

-0.09

0.04

0.06

-0.06

-0.17

3.90***

0.46

3.00***

4.11***

2.92***

1.85*

3.15***

5.13***

133

41

122

42

135

41

125

42

0.08

-0.02

0.07

0.22

0.03

0.05

0.08

0.46

0.05

0.00

-0.03

-0.06

0.01

0.01

-0.04

-0.12

1.58

0.05

1.94*

2.22**

0.39

0.22

1.65

3.30***

127

39

116

40

129

39

118

40

0.11

0.07

0.23

0.47

0.12

0.24

0.19

0.49

Trade openness Penn World Table 0.74

0.25

1.92*

0.53

167

43

0.02

-0.02

-0.07

-0.6

0.18

0.83

155

41

0.07

0.12

Source: World Bank staff calculations.

409


GOLDEN GROWTH

Table A7.7: OLS regression results of people’s values on initial government size (1) World

(2) Europe

Trust other people

(3) World

(4) Europe

Tolerance of diversity

(5) World

(6) Europe

(7) World

Gov. more responsib.

(8) Europe

Claiming benefits

Bivariate regression 0.01

0.01

0.02

0.04

0.01

0.05

-0.02

0

2.89***

2.44**

4.04***

6.95***

1.03

4.72***

2.82***

0.07

Coefficient Robust t-statistics

56

20

52

20

56

20

55

20

0.16

0.24

0.18

0.49

0

0.39

0.1

-0.06

Coefficient

0.00

0.00

0.02

0.02

0.02

0.03

-0.02

0.04

Robust t-statistics

1.53

0.46

2.71***

2.64**

0.84

1.82*

1.36

2.18**

Number of observations Adjusted R square Multivariate regression

Number of observations Adjusted R square

53

19

49

19

53

19

52

19

0.34

0.66

0.28

0.82

0.04

0.51

0.09

0.01

***, **, and * denote significance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: OLS refers to ordinary least squares. See note for table A7.6. Source: World Bank staff calculations, based on World Values Survey (waves 2004 to 2008).

Table A7.8: Public spending helps improve health, spending on public schooling is less effective (regression results for public spending in health and education, 1995–2009) Maternal Mortality Ratio Ln Government Spending (% of GDP)

-0.99

Ln Private Spending (% of GDP)

-0.09 (1.9)

(5.1)

Ln Age Dependency

1.2

(6.1)

Government Quality

-.43

(3.0)

Economic Controls (Openness, Debt Ratio)

YES

Political Institutions (Electoral System)

YES

Year Dummies

YES

Geo-group Dummies

YES

R2

0.83

No. Observations

819

First Stage R2

0.68

Sargan

chi2(1) .4368(p=0.51)

Net Secondary Enrollment Rates Ln Government Spending (% of GDP)

.22

Ln Age Dependency

-0.05 (0.6)

(3.3)

Government Quality

.09

(1.2)

Economic Controls (Openness, Debt Ratio)

YES

Year Dummies

YES

Geo-group Dummies

YES

R2

0.54

No. Observations

378

First Stage R2

0.59

Sargan First Stage R2 Sargan

Note: Instruments used are debt ratio in logs, federal structures in political institutions. t-statistics in parentheses. Source: World Bank staff calculations.

410

Chi2(4) 5.961(p=0.20) 0.68 chi2(1) .4368(p=0.51)


CHAPTER 7

Table A7.9: Regression results for log public pensions as a share of GDP Variables

(1) OLS

(2) RE

(3) FE

(4) OLS

1980-1994

(5) RE

(6) FE

1995-2007

OECD Log Old Age Dep. Ratio

0.9956***

0.9880**

0.9956*

0.8276***

0.8925***

Log PC GDP PPP

-0.2431***

-0.23930

-0.2431

-0.1392***

-0.1506**

-0.1392*

GDP Growth

-0.0082***

-0.0083***

-0.0082***

-0.0147***

-0.0154***

-0.0147**

Inflation Rate

-0.0081***

-0.0081**

-0.0081**

-0.0178***

-0.0176***

-0.0178***

0.0512

0.0471**

0.0512*

0.0046

-0.0029

0.0046

266

266

266

260

260

0.1845

0.9809

Democracy Index Number of observations Adjusted R squared

0.9314

0.8276***

260 0.3176

OECD Europe Log Old Age Dep. Ratio

1.0042***

0.9335

1.0042

0.6151***

0.7046**

0.6151

Log PC GDP PPP

-0.2580***

-0.2426

-0.258000

-0.0815**

-0.095200

-0.0815

GDP Growth

-0.0097**

-0.0101***

-0.0097**

-0.0157***

-0.0167***

-0.0157**

Inflation Rate

-0.0110***

-0.0110***

-0.0110***

-0.0210***

-0.0207***

-0.0210***

0.0456

0.0409

0.0456

0.0099

0.0037

0.0099

196

196

196

195

195

0.1787

0.9812

Democracy Index Number of observations Adjusted R squared

0.9130

195 0.218

***, **, and * denote significance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: The estimates are from a regression of the logarithm of public pensions as a share of GDP on the logarithm of the old-age dependency ratio, along with other controls. They include basic economic characteristics (GDP growth, per capita income, and the inflation rate) and a democracy index to capture any impact of elderly voters on pension entitlements. The regressions are run as pooled ordinary least squares (OLS), random effects (RE), and fixed effects (FE). In addition, we run separate regressions for 1980–94 and 1995–2007; as well as for the whole OECD group, including Australia, Canada, New Zealand, and the United States, and for the European OECD countries only. Source: World Bank staff calculations.

Table A7.10: Regression Results for Log Social Transfers as a share of GDP Variables

(1) OLS

(2) RE

(3) FE

(4) OLS

1980-1994

(5) RE

(6) FE

1995-2007

OECD Log Dependency Ratio

2.0234**

1.5682

2.0234

1.1568***

1.1589***

0.2885

0.24970

0.2885

-0.00560

-0.0075000

-0.0056

GDP Growth

-0.0087**

-0.0080***

-0.0087***

-0.0135***

-0.0137**

-0.0135**

Inflation Rate

-0.0185**

-0.0187*

-0.0185*

-0.0219***

-0.0221***

-0.0219***

-0.0062

-0.0109

-0.0062

92

247

247

0.4014

0.9455

Log PC GDP PPP

Democracy Index Number of observations Adjusted R squared

-0.2191** 92

92

0.9578

1.1568**

247 0.2591

OECD Europe Log Dependency Ratio

1.9568**

1.3012

1.9568

0.7310***

0.7351

0.7310

0.3568

0.325

0.356800

-0.049000

-0.050400

-0.0490

GDP Growth

-0.0071

-0.0065**

-0.0071**

-0.0140***

-0.0143*

-0.014

Inflation Rate

-0.0182*

-0.0179

-0.0182

-0.0297***

-0.0300***

-0.0297***

Democracy Index

0.1638*

-0.1334

-0.0114

67

67

Log PC GDP PPP

Number of observations Adjusted R squared

0.9458

-0.0114

-0.0155

67

182

182

0.3747

0.9253

182 0.1827

***, **, and * denote significance at the 1 percent, 5 percent, and 10 percent levels, respectively. Note: Dependent population includes population less than 15 years old, more than 64 years old, and the unemployed. For the estimation methods, OLS, RE, and FE refer to ordinary least squares, random effects, and fixed effects, respectively. Source: World Bank staff calculations.

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Notes 1

The United States does not have a European-style welfare state for, no doubt, related reasons. Most Americans seem to believe that redistribution favors minorities; they believe that the country is an open and fair society, so poverty is self-inflicted; and, probably because of these beliefs, political institutions, marked by a pluralist system and strong courts that traditionally consider private property more important than public interest, limit the scope of government (Alesina, Glaeser, and Sacerdote 2001).

2

The economic and social factors are as expected—except trade openness, which reduces government size. This could be because of the sample, which includes successful emerging economies with small governments and open economies.

3

Reinhardt and Rogoff 2011, (pp 31-34) defend their use of the 90 percent of GDP public debt threshold as follows: “Anyone who has done any work with data is well aware that mapping a vague concept, such as ‘high debt’ or ‘over-valued’ exchange rates to a workable definition for interpreting the existing facts and informing the discussion requires making arbitrary judgments about where to draw lines. … We do not pretend to argue that growth will be normal at 89 percent and subpar at 91 percent debt/GDP any more than a car crash is unlikely at 54mph and near certain at 56mph. However, mapping the theoretical notion of ‘vulnerability regions’ to bad outcomes involves defining thresholds, just as traffic signs in the US specify 55mph”.

412

4

A number of empirical studies find that social trust matters for strong institutions and growth. Knack and Keefer (1997) show that higher trust in strangers is correlated with better government performance. Nannestad (2008) and Jensen and Svendsen (2011) argue that social trust makes social welfare systems more sustainable. Aghion and others (2010) find that low trust leads voters to demand government regulation. This is because detailed regulation disciplines bureaucrats, and because voters prefer state control to private sector corruption. Similarly, Bergh and Bjørnskov (2011) show that countries with strong social trust have lower business and credit market regulations. Bjørnskov (2009) finds that a 10 percentage point increase in social trust is associated with an increase of 0.5 percentage point in the annual real growth rate.

5

The size of the fiscal saving depends on several assumptions, including the trends in enrollment rates and labor market participation rates, and physical infrastructure. Drawing on a more cautious set of assumptions, World Bank simulations find that potential saving amounts to 0.4 percent of GDP for the new member states and Croatia.

6

Austria, Belgium, Bulgaria, Cyprus, Denmark, Estonia, Finland, Georgia, Germany, Greece, Hungary, Iceland, Ireland, Italy, Lithuania, Luxembourg, the Netherlands, Portugal, Romania, the Slovak Republic, Spain, Sweden, Switzerland, Turkey, Ukraine, and the United Kingdom.


CHAPTER 7

References Abbas, S., O. Basdevant, S. Eble, G. Everaert, J. Gottschalk, F. Hasanov, J. Park, C. Sancak, R. Velloso, and M. Villafuerte. 2010. Strategies for Fiscal Consolidation in the Post-Crisis World. Washington, DC: IMF.

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Adema, W., and M. Ladaique. 2009. “How Expensive is the Welfare State? Gross and Net Indicators in the OECD Social Expenditure Database (SOCX).” OECD Social Employment and Migration Working Papers 92, OECD, Paris. Afonso, A., L. Schuknecht, and V. Tanzi. 2005. “Public Sector Efficiency: An International Comparison.” Public Choice 123 (3/4): 321–347. Afonso, A., L. Schuknecht, and V. Tanzi. 2010. “Public Sector Efficiency: Evidence for New EU Member States and Emerging Markets.” Applied Economics 42 (17): 2147–2164. Aghion, P., Y. Algan, P. Cahuc, and A. Shleifer. 2010. “Regulation and Distrust.” The Quarterly Journal of Economics 125 (3): 1015–1049. Aiginger, K. 2004. “The Economic Agenda: A View from Europe.” Review of International Economics 12 (2): 187–206. Alesina, A., and R. Wacziarg. 1998. “Openness, Country Size and Government.” Journal of Public Economics 69 (3): 305–321. Alesina, A., E. Glaeser, and B. Sacerdote. 2001. “Why Doesn’t the United States Have a European-Style Welfare State?” Brookings Papers on Economic Activity 2001 (2): 187–254. Atkinson, A., T. Piketty, and E. Saez. 2011. "Top Incomes in the Long Run of History." Journal of Economic Literature 49 (1): 3–71. Auerbach, A. 1985. “The Theory of Excess Burden and Optimal Taxation.” In Handbook of Public Economics, Volume 1, ed. A. Auerbach, and M. Feldstein: 61–127. Amsterdam: North-Holland. Barr, N. 1992. “Economic Theory and the Welfare State: A Survey and Interpretation.” Journal of Economic Literature 30 (2): 741–803.

Barrios, S., and A. Schaechter. 2008. “The Quality of Public Finances and Economic Growth.” European Economy Economic Papers 337, European Commission, Brussels. Barro, R. 1990. “Government Spending in a Simple Model of Endogenous Growth.” Journal of Political Economy 98 (5, Part 2): S103–S125. Barro R., and X. Sala-i-Martin. 1992. “Convergence.” Journal of Political Economy 100 (2): 223–251. Bayraktar, N., and B. Moreno-Dodson. 2010. “How Can Public Spending Help You Grow? An Empirical Analysis for Developing Countries.” Policy Research Working Paper 5367, World Bank, Washington, DC. Bergh, A., and C. Bjørnskov. 2011. “Historical Trust Levels Predict the Current Size of the Welfare State.” Kyklos 64 (1): 1–19. Bergh, A., and M. Henrekson. 2010. Government Size and Implications for Economic Growth. Washington, DC: AEI Press. Bergh, A., and M. Henrekson. 2011. “Government Size and Growth: A Survey and Interpretation of the Evidence.” Journal of Economic Surveys 25 (5): 872–897. Bergh, A., and M. Karlsson. 2010. “Government Size and Growth: Accounting for Economic Freedom and Globalization.” Public Choice 142 (1/2): 195–213. Besley, T., and T. Persson. 2011. “Fragile States and Development Policy.” Journal of the European Economic Association 9 (3): 371–398. Bjørnskov, C. 2009. “Economic Growth.” In Handbook of Social Capital: The Troika of Sociology, Political Science and Economics, ed. G. Svendsen, and G. Svendsen: 337–353. Cheltenham: Edward Elgar. Blanchard, O., and C. Cottarelli. 2010. “Ten Commandments for Fiscal Adjustment in Advanced Economies.” Blog post on iMFdirect, June 24. Available at blogimfdirect.imf.org/2010/06/24/ten-

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Harberger, A. 1987. “The Macroeconomics of Successful Development: What are the Lessons? Comment.” In NBER Macroeconomics Annual 1987, Volume 2, ed. S. Fischer: 255–258. Cambridge, MA: MIT Press. Hauner, D., and A. Kyobe. 2010. “Determinants of Government Efficiency.” World Development 38 (11): 1527–1542. IMF (International Monetary Fund). 2011. “Republic of Poland: Selected Issues.” IMF Country Report 11/167, July 2011, IMF, Washington, DC. Jensen, C., and G. Svendsen. 2011. “Giving Money to Strangers: European Welfare States and Social Trust.” International Journal of Social Welfare 20 (1): 3–9. Kaufmann, D., A. Kraay, and M. Mastruzzi. 2010. “The Worldwide Governance Indicators: Methodology and Analytical Issues.” Policy Research Working Paper 5430, World Bank, Washington, DC. Kielos, K. 2009. “Flight of the Swedish Bumblebee.” Renewal 17 (2): 61 –66. Knack, S., and P. Keefer. 1997. “Does Social Capital Have an Economic Payoff? A Cross-Country Investigation.” The Quarterly Journal of Economics 112 (4): 1251–1288. Kumar, M., and J. Woo. 2010. “Public Debt and Growth.” IMF Working Paper 10/174, IMF, Washington, DC. La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny. 1999. “The Quality of Government.” The Journal of Law, Economics, and Organization 15 (1): 222–279. Lindert, P. 2004. Growing Public: Social Spending and Economic Growth since the Eighteenth Century. Volume 1, The Story. Cambridge: Cambridge University Press. Lucas, R. 1988. “On the Mechanics of Economic Development.” Journal of Monetary Economics 22 (1): 3–42. Mandl, U., A. Dierx, and F. Ilzkovitz. 2008. “The Effectiveness and Efficiency of Public Spending.” European Economy Economic Papers 301, European Commission, Brussels. Meier, V., and M. Werding. 2010. “Ageing and the Welfare State: Securing Sustainability.” Oxford Review of Economic Policy 26 (4): 655–673. Nannestad, P. 2008. “What Have We Learned about Generalized Trust, If Anything?” Annual Review of Political Science 11 (1): 413–436.


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OECD (Organisation for Economic Cooperation and Development). 2010. Value for Money in Health Spending. Paris: OECD. OECD (Organisation for Economic Cooperation and Development). 2011a. Education at a Glance 2011: OECD Indicators. Paris: OECD. OECD (Organisation for Economic Cooperation and Development). 2011b. Pensions at a Glance 2011: Retirementincome Systems in OECD and G20 Countries. Paris: OECD. Olson, M. 1982. The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities. New Haven, CT: Yale University Press. Olson, M. 1986. "A Theory of the Incentives Facing Political Organizations: Neocorporatism and the Hegemonic State." International Political Science Review 7 (2):165–189. Pitlik, H., and M. Schratzenstaller. 2011. “Growth Implications of Structure and Size of Public Sectors.” WIFO Working Papers 404, Austrian Institute of Economic Research, Vienna. Razin, A., E. Sadka, and P. Swagel. 2002. “The Aging Population and the Size of the Welfare State.” Journal of Political Economy 110 (4): 900–918. Reinhart, C., and K. Rogoff. 2010. “Growth in a Time of Debt.” The American Economic Review 100 (2): 573–578. Reinhart, C., and K. Rogoff. 2011. “A Decade of Debt.” NBER Working Paper 16827, National Bureau of Economic Research, Cambridge, MA. Rodriguez, A., and M. Herbst. 2011. “Better Financing: Stronger Outcomes––A Public Sector Expenditure Review for the Education Sector in Poland.” World Bank Report 57305, World Bank, Washington, DC. Rodrik D., A. Subramanian, and F. Trebbi. 2004. “Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development.” Journal of Economic Growth 9 (2): 131–165. Rothstein, B. 2011. The Quality of Government: Corruption, Social Trust, and Inequality in International Perspective. Chicago, IL: University of Chicago Press. Sala-i-Martin, X., G. Doppelhofer, and R. Miller. 2004. “Determinants of Long-Term Growth: A Bayesian Averaging of Classical

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Spotlight Two Greening Europe’s growth Europe’s success in adopting an environmentally sustainable growth model depends on companies developing cutting-edge products, generating jobs at home, and competing successfully abroad. Gamesa, a Spanish wind turbine manufacturer, is considered a European green growth success story.1 Founded in 1976, the company moved into wind energy in 1994, and within 10 years it became the world’s second-largest turbine maker. Gamesa’s experience shows how growth comes with both opportunities and challenges.

Emissions Past to 1990

Present to 2008

Future to 2030

The maps show per capita CO2 emissions from fuel combustion. 1990 and 2008 data by country are from the International Energy Agency’s World Energy Outlook 2010. The 2030 map is based on an IEA scenario that limits atmospheric CO2 concentrations to 450 parts per million (ppm), consistent with a global temperature increase of 2 degrees centigrade.

Very high

High

Medium

Low

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Three points stand out: First, Europe’s production is greening thanks to popular policies.2 Consumption is becoming cleaner too, but less than one might think. Structural change plays an important role in these shifts. In much of Europe, the rise of hightech companies making green products contrasts with an overall decline in manufacturing. Between 2000 and 2010, the manufacturing employment share in Spain dropped about 20 percent, while imports of consumer goods from China increased eightfold. Polluting industries left, reducing local emissions, but emissions embedded in products imported from China rose. Spain’s net emissions imports increased almost fivefold between 1998 and 2008, similar to those of many other European countries (figure S2.1). For a truly green economic model, Europe needs even cleaner production, but it also needs cleaner consumption. Second, green policies and investments will create growth opportunities for European countries, but not all countries will benefit equally. Ambitious national and EU policies, motivated by environmental and job-creation objectives, encouraged Gamesa to enter the wind turbine business. These policies created a large home market for Gamesa’s products, which also helped enter export markets. By the mid-2000s, Gamesa had created more than 5,000 jobs, most of them in Spain. Besides Spain, Denmark and Germany were Europe’s main wind turbine manufacturers, together accounting for more than half of global production by 2007. These countries used incentives to create domestic demand and develop research and innovation capacity. As national green policies expand in Europe, will many countries see growth and jobs benefits? Or will such benefits be confined to a small group of early market leaders? Third, some economic benefits of EU green policies will leak outside the European Union. This leakage is expected and should be welcomed. Addressing global environment imperatives requires that many countries contribute, especially the world’s largest economies: the European Union, the United States, and China. Gamesa’s experience is illustrative. In 2005, Gamesa held a third of the Chinese wind turbine market. Five years later, its market share was down

Figure S2.1: Europe is the world’s largest importer of carbon dioxide (net carbon dioxide emission transfers [territorial minus consumption emissions], 2008) Note: MtCO2 = million tons of carbon dioxide. Source: World Bank staff, using data from Peters and others (2011).

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to 3 percent. The company entered the Chinese market early, but as green technology became a higher priority for the Chinese government, preferences for domestic industry forced Gamesa to transfer know-how and technology to Chinese suppliers. Some of the policies that helped Gamesa in Spain—including local content requirements and cheap land and credit—now helped Chinese wind turbine manufacturers. Today, some of Gamesa’s products are 95 percent Chinese, and 4 of the 10 largest wind turbine makers in the world are Chinese. Despite its shrinking market share, Gamesa’s Chinese business grew, and the company did not protest Chinese policies. In 2010, Gamesa opened its fifth manufacturing facility in China, from where it now ships equipment to North America. While Gamesa dropped to sixth place among global wind turbine companies, its revenues increased from $1.7 billion in 2005 to $3.3 billion in 2009. During this time, globally installed wind energy capacity rose from 60 gigawatts to 160, and by 2010 reached almost 200. Helped by technological progress and economies of scale, the price for wind power dropped about 27 percent.3 Europe’s efforts alone are not enough to tackle global environment problems like climate change. Green technology investments will happen sooner if global innovation and manufacturing networks are mobilized. Europe will not always be able to compete in mass-producing standardized green products. It will need to retain its strength in knowledge-intensive green services and technology and rely on cheaper production in places such as the EU12, the EU candidate and eastern partnership countries, and even in East Asia. If Europe succeeds, its growth model will not just be the best in the world in helping its poorer parts and neighbors prosper, it will also lead the world to a greener future.

The green golden rule Environmental policies have been essential in Europe since the early 1970s (Hey 2005). They have been outlined in six environmental action programs and formalized in numerous directives.4 Early policies focused on local environmental quality: highly visible but mostly reversible environmental problems that could be eliminated or reduced by strict emission and effluent standards, such as air and water quality. More recently, Europe has focused on environmental problems with less visible impacts but nonetheless severe and potentially irreversible effects. Global threats such as climate change, biodiversity loss, and nuclear waste now command Europe’s attention. This second type of environmental problem poses new challenges. These complex problems resemble other large societal problems, like poverty or public health, with long-term consequences and no easy solutions (Hulme 2009). There is great danger in postponing action until future welfare diminishes and the ability to manage or reverse harmful trends is lost. These long-term threats call for a “green golden rule”—achieve the highest level of growth and welfare that does not diminish future generations’ ability to benefit from environmental goods and services.5 Considering the welfare of both current and future generations means that environmental policymaking must walk a fine line. Reducing carbon emissions, for instance, costs both firms and consumers. Given the uncertainty about the

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GOLDEN GROWTH

effectiveness of policies and the impacts they avoid, determining the level of climate action that reduces emissions enough to avoid future damages without unduly affecting economic growth will be difficult. It implies determining the “optimal” or acceptable level of pollution—a controversial task. Following the green golden rule, Europe has embarked on an ambitious program to ensure continuing growth with fewer environmental side effects. Policymakers still worry about employment, social stability, and fiscal balances, but protecting natural resources long considered practically free and inexhaustible is now prominent and, in some countries, just as important. If Europe overcomes the significant technical, financial, political, and social barriers to implementing a green economy, it will become a world model—one with lessons for both developed countries that urgently need to reduce their environmental impacts and developing countries that need to achieve higher incomes without excessive environmental degradation.

Greening Over the last two decades, Europe has improved environmental quality in many areas and reduced the impacts of its production. Europe measures its environmental progress in climate change, environmental health, nature and biodiversity, and natural resources and waste. Major sources of local air pollution in the EU15 dropped 30–70 percent over 1990–2008 (figure S2.2). Organic water pollution dropped almost 20 percent since 1998, and fine particulate matter dropped 20 percent on average (European Environment Agency 2010). Despite a commitment to reduce waste generation and materials consumption, both have increased modestly, but far less than economic output. But Europe’s progress on biodiversity conservation has been mixed. It did not reach its goal of halting biodiversity loss by 2010, despite making progress in habitat conservation and introducing biodiversity concerns in sector policies, such as the Common Agricultural Policy.

Figure S2.2: Advanced Europe has cut air pollution in half since 1990 (trends in air pollution in the EU15, 1990–2009, 1990 = 100) Note: Excluding the United Kingdom (no pre-2000 data). Source: European Environment Agency 2010.

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SPOTLIGHT TWO

Figure S2.3: Europe’s north is leading the push for cleaner energy (percentage of final energy from renewables in 2009—and the targets for 2020) Source: REN21 2011.

EU climate policies sometimes veer into micromanagement (a recent directive limits carbon dioxide emissions in producing a ton of toilet paper to no more than 334 kilograms), but they have been effective. While in most parts of the world, greenhouse gas emissions have increased, over 1990–2008 they dropped 7 percent in the EU15 and 11 percent in the EU27, despite a considerable increase in economic activity (European Environment Agency 2010).6 Europeans are also using energy more efficiently. Europe’s 2008 economic output per unit of energy was twice that in 1990. By further decoupling economic growth from energy use and emissions, the European Union is on track to achieve its climate policy goals for 2020: reduce greenhouse gas emissions 20 percent below 1990 levels, lower primary energy use to 20 percent less than “business as usual,” and obtain at least 20 percent of energy from renewable sources. Some member states have already met some goals, for instance on renewable energy (figure S2.3). The targets are more ambitious for 2050, as the European Union aims for an 80 percent reduction in emissions. These gains have come from popular policies. One instrument for climate action is the European Emission Trading Scheme, introduced in 2005. Despite criticism of the scheme’s effectiveness and susceptibility to windfall profits and fraud, industries now know there will be a long-term price on atmospheric carbon emissions. The scheme encouraged private investments in abatement technology and upgrading equipment. Europeans have shown a willingness to share the cost of environmental action. Indeed, 64 percent of EU15 residents believe that protecting the environment should be a priority, even at the

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expense of job loss and slower economic growth, compared with 58 percent in the rest of the world (World Values Survey 2005–2008).7 Environmental policies can win increased popular support by spreading financial benefits. Many Danish wind turbines are owned by local cooperatives, preempting “not-in-mybackyard” opposition. And feed-in tariffs for renewable electricity generation have been turning home-based solar systems into investment opportunities. Europe’s progress in reducing local air pollution and the climate impacts of production is substantial, but its gains in shrinking the environmental footprint of consumption are more limited. Lower industrial pollution is due at least in part to major structural economic shifts and trade expansion. As traditional, energy- and emission-intensive economic activities (such as iron and steel manufacturing) became uncompetitive in higher-wage European countries, they moved to other parts of the world, especially Asia. The EU15’s total steel output has stagnated since 1980, when Europe moved into more specialized and cleaner steel production. By contrast, India’s and the Republic of Korea’s output increased some 600 percent, China’s by almost 1,600 percent.8 Europe’s environmental dividend reduced local pollution from dirty industries and generally decreased use of local resources, a contrast with the increase in other regions. Figure S2.4: Western imports, Eastern emissions

1,400

(net emission transfers, 1991–2008)

1,200 1,000

Source: Peters and others 2011.

800 600 400 200 0 –200 –400 –600

Sometimes polluting industries quite literally moved to developing countries. In the late 1990s, Chinese companies purchased dozens of German industrial plants and dismantled, shipped, and rebuilt them in China. A Dortmund steel mill, for example, became a 250,000-ton three-dimensional puzzle (Kahn and Landler 2007). Air quality improved in Germany, but the shift increased air pollution in China (Chen, Hong, and Kan 2004).9 Many Asian products are made for European markets, leading to rising emissions embedded in imports. Between 1990 and 2008, the United Kingdom’s net imports of carbon dioxide emissions increased from 29 million tons to 159 million tons (figure S2.4). Overall, when considering only carbon dioxide emitted in rich (Kyoto Annex B)

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countries, there has been a 3-percent drop. By contrast, consumption-related emissions in those countries increased 11 percent (Peters and others 2011).10 China alone has more than tripled its exports of emissions since 2000. Europe has made progress in greening its production and has led the world in formalizing and implementing regional emission-reduction policies. But more action is needed. Marginal abatement costs will increase as cheaper clean-up solutions are implemented first, and tightening environmental regulations will become politically more difficult, especially at a time of economic uncertainty. Beyond its borders, Europe needs to green its consumption. One approach is to help other countries reduce the environmental impacts of their production while accelerating resource use. The European Union, already providing technical assistance for pollution and emission control, recycling, and other environmental priorities through bilateral and multilateral efforts (including through the World Bank), could do more by supporting European exports of environmental technology and more efficient capital goods to developingcountry producers, through export credit guarantees, for example. Measures that encourage green foreign direct investment would help develop domestic environmental technology firms. A more coercive approach would be to extend the reach of European emission policies to other countries through border tax adjustments (Umweltbundesamt 2009). This would level the playing field for domestic companies, and foreign firms exporting to Europe would then have the same incentives to reduce emissions as do domestic producers. The debate about the inclusion of foreign air carriers in the European Emission Trading Scheme in 2012 shows that this approach is controversial, but it might encourage domestic carbon restrictions so that revenues stay in the exporting country. The European Commission and several European countries contributed to the World Bank–led Partnership for Market Readiness, which helps countries set up carbon markets. The first round of countries includes China, Turkey, and Ukraine.

Green growth Moving toward a European economy that puts a price on environmental goods and services involves a substantial structural shift. Further reducing local pollution and preventing global environmental problems from severely affecting current and future generations require massive transformations in energy, transport, and housing. Some observers have called for an energy industrial revolution.11 But change of this magnitude is not unprecedented. Both the information technology revolution and the invention of the steam engine triggered upheaval far greater than what one might expect from a greengrowth transformation (Fankhauser, Sehlleier, and Stern 2008). An energy industrial revolution will impose costs on some businesses but benefit others. How these costs and benefits are distributed will determine whether green growth will be a broadly accepted economic model in the EU27 and beyond. Tighter environmental standards will be costly, at least in the short to medium term. Unilaterally internalizing the cost of environmental degradation will render European firms less competitive than firms not subject to strict pollution controls. The money that consumers and firms spend on pollution charges or

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energy will not be available to spend or invest elsewhere (though these costs can be partly neutralized through appropriate revenue recycling). Predicting these costs of green policies is difficult. The costs of a proposed carbon capand-trade system in the United States, for instance, would range from $69 to $808 per household by 2020 (Winchester and others 2010). A study for the European Commission estimated firm-level costs of environmental compliance at 0.25–2 percent of production value (Vercaemst and others 2007). In Poland, the average cost to implement a comprehensive greenhouse gas abatement package is about 1 percent of GDP over 20 years, after which net benefits accrue (World Bank 2011). These costs, though significant, are not enough to explain the exodus of energy-intensive and polluting industries out of Western Europe. High labor costs and other production factors have likely played a larger role. Energy prices are already high, and most EU15 countries moved out of energy- and emission-intensive industries some time ago, such as the United Kingdom, with its 1980s decline in the coal and steel industry. The impact will be larger in Eastern Europe, where economies have not yet completed structural shifts and where national environmental policies are more lenient. Environmental action comes with costs, but so too does inaction.12 And sometimes doubted decisions become obvious in retrospect. The automobile industry and many consumers initially rejected catalytic converters as too expensive. But the averted costs of respiratory illnesses and other benefits from reduced urban smog have been significant. With increased production and technical progress, a catalytic converter today is a tiny fraction of the cost of a car. Proponents of stricter environmental standards argue that green policies have sizable growth effects. Vehicle pollution abatement has generated new business opportunities—for example, the global catalytic converter industry is worth $20 billion today. And because green technologies are less mature, they require more innovation and research and development, which generate high-value jobs. At the lower end, investments in energy efficiency and cleaner energy generate jobs in installation, operation, and maintenance that cannot be outsourced. The job gains in green industries are not small, though they are as difficult to determine as the costs of environmental regulation. By the late 2000s, the wind energy sector was thought to have generated some 100,000 jobs in Germany, 42,000 in Spain, and 22,000 in Denmark, and for the solar photovoltaic (PV) sector, some 70,000 jobs in Germany and 26,000 in Spain (REN21 2011). European firms are highly competitive in such areas as pollution-abatement technology and solid waste management, and job gains in these sectors are significant as well. Experience shows that policies matter. An ecological tax reform is credited with helping Germany reduce emissions and increase employment. The reform raised the cost of energy, triggering large efficiency gains. The increased revenue was used to reduce nonwage labor costs, which helped create 250,000 jobs (Rayment and others 2009, Iwulska 2011). Economic gains have been concentrated in a few countries, mostly in the EU15. These countries have had government support, large home markets for green products, and the capacity to take advantage of green growth opportunities (figure S2.5). Denmark, France, Germany, Spain, and the United Kingdom, each accounting for between €5 billion and €15 billion in clean energy technology

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sales in 2008, were far ahead of Poland (the leader in Eastern Europe), which had less than €300 million (van der Berg and van der Slot 2009). Figure S2.5 shows a similar pattern in value added from renewable power technologies. The market leaders ensured domestic demand through, among other steps, feed-in tariffs for clean energy and supported technology development. In 2009, Germany alone spent about €64 million on publicly funded research and development for solar PV technology, complementing €163 million in private research (Wissing 2009).13 Employment and economic opportunities also exist in other EU countries. With carbon trading, one would expect abatement investments to flow to EU12 countries, where energy and emission intensities

Figure S2.5: Germany, France, Sweden, and Italy have helped business by encouraging renewable energy (total gross value added induced by renewable energy deployment in 2005, by expenditure category, billion euros) Source: Ragwitz and others 2009.

remain higher than in the EU15. But the resulting jobs will likely be smaller in number and lower in skill and value added. Examples include manufacturing and assembling green products, upgrading building energy efficiency, and producing biofuel. High-value-added activities, green intellectual property, and earnings from green exports will likely remain concentrated in today’s leading green economies. All EU countries must adhere to the same environmental standards and carbon policy. While all EU countries bear the costs of green growth policies, not all have the structural endowments to take advantage of the opportunities these policies generate. An analogy to the eurozone is illustrative. Countries adopted a common currency without first resolving structural differences. The countries shared the benefits of adopting the euro, such as low interest rates and reduced trade friction. They also faced the constraints imposed by a single currency, but with different structural and economic capabilities to adjust to the loss of monetary flexibility. Over the last several decades, EU interventions (such as the structural funds) have tried to reduce these differences—but with limited success. A single carbon price has similar advantages and drawbacks. The effectiveness of the European green-growth model—especially in Southern and Eastern Europe—will depend on policy instruments that help countries cope with the

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burdens and share the benefits of the transformation to a cleaner economy. Besides external support (through carbon finance, for instance), green growth requires political commitment by countries that, rather than embrace new opportunities, often cling to sunset industries and fossil fuel–based energy systems. Europe missed many of the efficiency gains of the infotech revolution. It will have to be smarter to prosper in the green technology revolution.

Global green growth Europe is serious about greening its economy. Strong policies opened economic opportunities that European firms like Gamesa were quick to exploit. But in an open economy, the incentives that benefit domestic producers also benefit foreign producers who export to the European market. This increases competition for European firms and implies a leak of taxpayer-funded subsidies and other support. If the goal is to tackle global environmental challenges, however, these leaks will be beneficial even as they make it more difficult for Europe’s green enterprises to compete. By far the biggest barrier to a green transformation is cost. Environmentally friendly technologies are often more expensive than conventional alternatives. For example, electricity from coal-fired power stations costs about $0.06 per kilowatt hour (kWh), while the price of wind energy ranges between $0.08 and $0.14 per kWh. Solar photovoltaic power (PV) costs more than $0.20 per kWh (REN21 2011). Even where life-cycle costs are lower—as with the new generation of energy-efficient lighting—high initial costs deter consumers. Reducing costs requires research and development, innovation, and economies of scale. With every doubling of production, wind energy is expected to become 15–20 percent cheaper, and solar PV prices to drop 25 percent (Neij 2008). Regulation, taxes and subsidies, and public investments that reduce the price of clean technologies (or increase the cost of dirtier ones) trigger private investment and lead to increased scale. These interventions are justified because they compensate for nonpriced costs incurred by conventional technologies, such as the health effects of air pollution, the loss of such environmental services as natural water filtration, and the damages from a warmer, wetter, more variable climate.14 The opportunity to get a foothold in emerging markets for green goods also motivates many countries. Through EU directives and national policies, European countries have made credible commitments to support clean growth. These commitments should encourage investors to risk funding new products that are not profitable according to current market prices. Generous subsidies and tariff guarantees have been effective, helping European leaders emerge in many green technology areas. By the late 2000s, environmental technologies accounted for almost 10 percent of GDP in Germany, and German firms held global market shares of 6–30 percent in key green markets (BMU 2009).15 Public incentives have worked for European companies, but with open trade they are also attractive to foreign firms. U.S. companies, such as General Electric and smaller high-tech firms, quickly established distribution systems in Europe. As some green technologies move from research labs to mass production, Europe’s comparative advantage vanishes and low-cost producers enter the

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market. Solar PV panels are an example. Generous feed-in tariffs in Germany, Spain, and other European countries initially benefited domestic firms, even causing a bubble in solar company stocks. This attractive market triggered large investments in production capacity in China. Between 2006 and 2010, China’s PV production increased twentyfold, from 400 megawatts to 8,000. During this time, the export share of panels in China never dropped below 94 percent, because the high price and low local subsidies meant that there was almost no domestic market.16 In wind energy, which is more cost-competitive with conventional sources, Chinese firms have also increased production. Most of the demand so far is domestic, as China deploys the largest installed wind capacity in the world. But that will change as producers increase capacity and eye new markets. European firms, such as Gamesa, should expect more competition. Europe should welcome these developments. Competition and rising capacity have substantially reduced the prices of some green products. China’s solar expansion coincided with a price drop of more than 40 percent,17 making it cheaper for Europe to reach its “20-20-20” targets (a 20 percent cut in greenhouse gas emissions by 2020, a 20 percent increase in the share of renewable energy, and a 20 percent cut in energy consumption) and creating room for cuts in subsidies. By indirectly contributing to faster price declines, European policies benefit green investments in the rest of the world, accelerating greener industrialization in developing and emerging nations. The EU27 accounts for just 13 percent of global emissions (International Energy Agency 2010). This share will drop as the populations and economies of other regions grow faster than Europe’s. To limit global warming and reduce other global environmental threats, Europe must spread technology and know-how to places where environmental pressures will be most severe. Sharing technology with other regions will also reduce the emissions embedded in European imports. Even if much of the resulting economic activity takes place elsewhere, Europe is positioned to capture a large share of what some expect to be a €3.1 trillion market for green technology by 2020 according to a study by Roland Berger Strategy Consultants in 2007.18 This will include exports of advanced green-tech products to China, which will require environmental technology investments estimated at 12 percent of GDP. Chinese solar panels, for instance, are produced with machines made in Europe. Rather than compete on price, Europe should accept that manufacturing and assembly of basic green technology will move to countries with lower factor costs—including perhaps the EU12 and eastern partnership countries. Europe should promote innovative, high-tech companies that create green products and services that are less price-sensitive and less easily reproduced elsewhere. Europe needs “Green Apples”—the green-tech equivalents of an innovative info-tech company. Apple Inc. profits from innovation and design, not from manufacturing. Similarly, European green technology firms should focus on developing and retaining intellectual property and on specialized manufacturing, engineering, and related high-value-added activities. This focus will require support for applied research in Europe that makes the region attractive for non-European companies. Suzlon, a large Indian wind turbine manufacturer, maintains six of its eight research centers in Europe because of Europe’s accumulated know-how.

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Needed: will, ingenuity, and efficiency Europe is already the leader in the transition to a greener economy. But environmental impacts, especially greenhouse gas emissions, are still too high per capita to reach global targets. And the picture is even grayer when considering the complete consumption footprint. In recent years, European policies have moved global climate goals forward. But the world’s second- and third-largest economies might soon match Europe’s green ambitions. The United States has one of the largest environmental footprints. But it also has the most effective academic research capacity—and huge innovation potential. Much of basic climate-change science and many technical innovations —such as solar, wind, and battery technology—originated in U.S. labs. The United States is strong not only in technical innovation but also in financial and policy innovation. Venture capital funds in the United States channel vast resources to promising firms, including those in green technology. While Europe is strong in process innovation and technological improvement, U.S.-style risk-taking is more likely to lead to the breakthrough technical innovations that many believe are necessary to solve the climate problem. Federal climate action in the United States has been inadequate, but state and local policies show American potential. California’s air pollution standards have affected car manufacturing globally, and the state’s energy policy began decoupling power consumption from growth in the 1970s (Iwulska 2011). Concerns about acid rain in New England spurred the development of a sulfur dioxide allowance trading system, which showed the feasibility of market-based instruments for pollution control. Ten eastern states joined the Regional Greenhouse Gas Initiative, a cap-and-trade mechanism to reduce carbon dioxide emissions from the power sector. Twenty-three states and many local jurisdictions have set quantitative targets to reduce their greenhouse gas emissions, and more than thirty states have adopted renewable energy portfolio standards for utilities (Pew Center on Global Climate Change 2011).

Figure S2.6: China now emits the most carbon dioxide

7,000

(total carbon dioxide emissions from energy use in the three largest global economies, million tons of carbon dioxide)

6,000

4,000

Source: International Energy Agency 2010b.

3,000

5,000

2,000 1,000 0

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Figure S2.7: But China’s per capita carbon dioxide emissions may not significantly grow beyond the European Union’s (per capita carbon dioxide emissions from energy use in the three largest global economies, tons of carbon dioxide per capita) Note: Solid lines show observed per capita emissions, and dotted lines show a per capita emission scenario based on 450 ppm with ambitious mitigation. Source: World Bank staff calculations based on International Energy Agency (2010) and UN (2011).

The capacity for policy experimentation and implementation at the state and local levels can lead to new, effective, and socially acceptable approaches to environmental management. When successful, innovation spreads quickly and regulatory diversity helps lift standards elsewhere. The “California effect” works even without strong federal action (Vogel 2000). But in the long term, state action cannot substitute for national policies. China, the world’s largest emitter of greenhouse gases, faces severe problems from air and water pollution. But to further reduce poverty, China’s economy must continue growing—even if double-digit growth rates will become harder to achieve. At current emissions per unit of GDP, China’s economic growth implies that by 2030 the country would account for the entire global emission allowance —30–35 billion tons of carbon dioxide equivalent—that is consistent with the target of keeping Earth’s temperature from rising 2°C higher than preindustrial levels (Stern 2010). China has started tackling this enormous challenge. Aware of its own susceptibility to climate change, the country has embarked on an ambitious domestic greening program. The twelfth Five-Year Plan calls for a 15– 17 percent reduction in energy and carbon dioxide intensity by 2015, expansion of wind farms, new solar capacity of more than 5 gigawatts, construction of a smart grid to integrate a larger share of renewables, an emissions cap-andtrade system, and a tax on coal. China already contributes to global greening by lowering the cost of existing environmental technology, from light bulbs to solar water heaters to wind turbines. All seven strategic industries in the Five-Year Plan move the country from low-end manufacturing to a less resource-intensive economy. And three are explicitly green: new energy, new-materials and new-energy cars, and energy saving and environment protection. China’s huge market for green products will also reduce the price gap between clean and conventional energy and technology. Its goal is to become the world leader in green products like solar panels and electric cars, whose markets must grow if global emission targets are to be reached. China’s environmental impacts will continue to rise. But with strong commitments and better technologies, it could reverse the rapid

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growth of emissions (figures S2.6 and S2.7) and reach higher incomes at lower levels of per capita pollution and atmospheric emissions than many of today’s industrialized countries. Europe can help the global environment by continuing to pursue a greener growth model. The region’s continuing green growth will improve the quality of life for its current and future citizens, contribute to global sustainability, and offer economic opportunities for European firms. Europe will incur shortterm costs, although the implications of failing to deal with long-term global environmental threats are less severe for Europe than other regions. Europe has already dealt with most local pollution and will be less severely affected by global climate change than many other regions.19 European leadership on environmental action is, therefore, even more remarkable. But despite Europe’s leadership, solving the toughest global environmental problems will require all three major economies to accelerate the transition to greener growth and nudge the world forward. Indeed, global green growth requires European political will, American innovation, and Asian efficiency. Uwe Deichmann contributed this spotlight.

Notes 1

2

Based on Lewis and Wiser (2007), Bradsher (2010), Gamesa annual reports, and market share information from Make Consulting and Emerging Markets Energy Research. There are numerous definitions of “green growth” (OECD 2011) or “green economy” (UNEP 2011). This spotlight uses the term “greening” in a broader sense of reducing the environmental impacts of human activity; it uses “green growth” in a narrower sense of recognizing a shift to greater environmental sustainability as an opportunity for growth—through innovation and development of new products and markets. Both terms refer to traditional environmental problems (like water pollution or excessive resource use) as well as climate change.

3

Consistent cost estimates for wind power are hard to find. This figure assumes the widely accepted learning rate of 20 percent reduction with a doubling of capacity.

4

Refer to the European Commission’s website on environment policies for a list of directives, available at ec.europa. eu/environment/policy_en.htm.

5

Beltratti, Chichilnisky, and Heal (1995) note that this is “the highest indefinitely maintainable level of instantaneous utility, in a framework where environmental goods are valued in their own rights, i.e., are a source of utility, and are used as inputs to the productive process” (p. 151).

6

Part of that decrease was due to industrial restructuring and inefficient socialist-era industries closing.

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7

In the EU12, just 50 percent agree.

8

World Bank staff calculations based on data from the World Steel Association (www.worldsteel.org).

9

There appear to be no estimates of displaced industries’ contributions to China’s local air pollution. But it is likely significant through increased energy demand (much of it from coal) and direct emissions from industrial processes. More recently, China has reduced urban air pollution substantially, including through the World Bank–supported China Air Pollution Management Project.

10

11

12

Aggregate estimates for EU15 or EU27 are unavailable, because the data set does not allow netting out intra-European trade-induced emissions. Annex B countries are high- and middle-income countries subject to emissions reductions in the Kyoto Protocol, including Russia and Ukraine. See http://unfccc.int/ kyoto_protocol/items/3145.php for a list. For example, Nicholas Stern (presentation at the High-Level Dialogue on Low Emissions Development Policy Implementation, July 13, 2011, World Bank, Washington, DC. Available at climatechange.worldbank.org/content/ climate-change-thinkers-converge-highlevel -dialogue-low-emission-development). See the extensive literature on the health burden of environmental pollution and the emerging literature on climate change adaptation costs (for instance, World Bank 2010a).

13

The private sector figure is for 2008. Globally, spending on clean energy research and development is considered far too low to support the kinds of technological breakthroughs needed to achieve climate goals (World Bank 2010b).

14

See, for instance, Gillingham, Newell, and Palmer (2009) for a discussion of market failures in energy efficiency that justify government intervention.

15

These markets include energy efficiency, sustainable water, sustainable transport, energy generation, waste management and recycling, and natural resources and efficiency of materials use.

16

International Energy Agency 2010c.

17

Price data are available on the website of Solarbuzz, an NPD Group Company, at solarbuzz.com/facts-and-figures/retail-price -environment/module-prices.

18

Presentation is available at www. rolandberger.com/media/pdf/ rb_press/RB_Wirtschaftsfaktor_ Umweltschutz_20071127.pdf.

19

For evidence of Europe’s generally lower climate change risk compared with those of other regions, see Buys and others (2009) and the Climate Change Vulnerability Index released by Maplecroft, available at maplecroft.com/about/news/ccvi.html.


REFERENCES

References Beltratti, A., G. Chichilnisky, and G. Heal. 1995. “Sustainable Growth and the Green Golden Rule.” In The Economics of Sustainable Development, ed. I. Goldin and L. Winters: 147–166. New York: NY: Cambridge University Press. BMU (German Federal Ministry for the Environment, Nature Conservation and Nuclear Safety). 2009. GreenTech Made in Germany 2.0: Environmental Technology Atlas for Germany. Berlin: BMU. Bradsher, K. 2010. “To Conquer Wind Power, China Writes the Rules.” New York Times, December 14. Buys, P., U. Deichmann, C. Meisner, T. Ton That, and D. Wheeler. 2009. “Country Stakes in Climate Change Negotiations: Two Dimensions of Vulnerability.” Climate Policy 9 (3): 288–305. Chen, B., C. Hong, and H. Kan. 2004. “Exposures and Health Outcomes from Outdoor Air Pollutants in China.” Toxicology 198 (1–3): 291–300. European Environment Agency. 2010a. Annual European Union Greenhouse Gas Inventory 1990–2008 and Inventory Report 2010. Copenhagen: European Environment Agency. Fankhauser, S., F. Sehlleier, and N. Stern. 2008. “Climate Change, Innovation and Jobs.” Climate Policy 8 (4): 421–429. Gillingham, K., R. Newell, and K. Palmer. 2009. “Energy Efficiency Economics and Policy.” Annual Review of Resource Economics 1 (1): 597–619. Hey, C. 2005. “EU Environmental Policies: A Short History of the Policy Strategies.” In EU Environmental Policy Handbook: A Critical Analysis of EU Environmental Legislation, ed. S. Scheuer: 17–30. Brussels: European Environmental Bureau.

Hulme, M. 2009. Why We Disagree About Climate Change: Understanding Controversy, Inaction and Opportunity. New York, NY: Cambridge University Press. International Energy Agency. 2010b. World Energy Outlook 2010. Paris: International Energy Agency. International Energy Agency. 2011. “PVPS Annual Report 2010: Implementing Agreement on Photovoltaic Power Systems.” Report by Photovoltaic Power Systems Programme (PVPS), International Energy Agency, Paris. Iwulska, A. 2011. “Country Benchmarks.” Prepared for this report. Available at www. worldbank.org/goldengrowth. Accessed January 23, 2012. Kahn, J., and M. Landler. 2007. “China Grabs West’s Smoke-Spewing Factories.” New York Times, December 21. Lewis, J., and R. Wiser. 2007. “Fostering a Renewable Energy Technology Industry: An International Comparison of Wind Industry Policy Support Mechanisms.” Energy Policy 35 (3): 1844–1857. Neij, L. 2008. “Cost Development of Future Technologies for Power Generation—A Study Based on Experience Curves and Complementary Bottom-Up Assessments.” Energy Policy 36 (6): 2200–2211. OECD (Organisation for Economic Cooperation and Development). 2011. Towards Green Growth. Paris: OECD. Peters, G., J. Minx, C. Weber, and O. Edenhofer. 2011. “Growth in Emission Transfers via International Trade from 1990 to 2008.” Proceedings of the National Academy of Sciences 108 (21): 8903–8908. Pew Center on Global Climate Change. 2011. “Climate Change 101: Understanding and Responding to Global Climate Change.” January 2011 Update, Pew Center on Global Climate Change, Arlington, VA.

Ragwitz, M., W. Schade, B. Breitschopf, R. Walz, N. Helfrich, M. Rathmann, G. Resch, C. Panzer, T. Faber, R. Haas, C. Nathani, M. Holzhey, I. Konstantinaviciute, P. Zagamé, A. Fougeyrollas, and B. Le Hir. 2009. “EmployRES – The impact of renewable energy policy on economic growth and employment in the European Union.” Report prepared for the Directorate-General for Energy and Transport in the European Commission, Fraunhofer ISI, Karlsruhe. Rayment, M., E. Pirgmaier, G. De Ceuster, F. Hinterberger, O. Kuik, H. Leveson Gower, C. Polzin, and A. Varma. 2009. “The Economic Benefits of Environmental Policy.” Report for a project under the Framework contract for economic analysis of environmental policies and of sustainable development, ENV.G.1/FRA/2006/0073 – 2nd, Institute for Environmental Studies, VU University Amsterdam, Amsterdam. REN21. 2011. Renewables 2011 Global Status Report. Paris: REN21 Secretariat. Stern, N. 2010. “China’s Growth, China’s Cities, and the New Global Low-Carbon Industrial Revolution.” Policy Paper, November, Centre for Climate Change Economics and Policy, Grantham Research Institute on Climate Change and the Environment, London School of Economics, London. Umweltbundesamt (German Federal Environment Agency). 2009. “Border Tax Adjustments for Additional Costs Engendered by Internal and EU Environmental Protection Measures: Implementation Options and WTO Admissibility.” Climate Change 07/2009, Umweltbundesamt, Dessau. UN (United Nations). 2011. World Population Prospects: The 2010 Revision, CD-ROM Edition. New York, NY: UN. UNEP (United Nations Environment Programme). 2011. Towards a Green Economy: Pathways to Sustainable Development and Poverty Eradication. Paris: UNEP.

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van den Berg, W., and A. van der Slot. 2009. “Clean Economy, Living Planet: Building Strong Clean Energy Technology Industries.” Report prepared by Roland Berger Strategy Consultants, World Wildlife Fund-Netherlands, Zeist. Vercaemst, P., S. Vanassche, P. Campling, L. Vranken, P. Agnolucci, R. Salmons, B. Shaw, J. Jantzen, H. van der Woerd, M. Grünig, and A. Best. 2007. “Sectoral Costs of Environmental Policy.” Study accomplished under the authority of the European Commission, DG Environment, 2007/ IMS/R/427, VITO, Mol. Vogel, D. 2000. “Environmental Regulation and Economic Integration.” Journal of International Economic Law 3 (2): 265–279. Winchester, N., S. Paltsev, J. Morris, and J. Reilly. 2010. “Costs of Mitigating Climate Change in the United States.” Annual Review of Resource Economics 2 (1): 257–273.

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Wissing, L. 2011. “National Survey Report of PV Power Applications in Germany 2010.” Report prepared on behalf of BMU – German Federal Ministry for the Environment, Nature Conservation and Nuclear Safety, for International Energy Agency Co-operative Programme on Photovoltaic Power Systems, Forschungszentrum Jülich, Jülich. World Bank. 2010a. World Development Report 2010: Development and Climate Change. Washington, DC: World Bank. World Bank. 2010b. “Economics of Adaptation to Climate Change: Synthesis Report.” Report prepared by the Environment Department, World Bank, Washington, DC. World Bank. 2011. “Transition to a LowEmissions Economy in Poland.” Report prepared by Poverty Reduction and Economic Management Unit, Europe and Central Asia Region, World Bank, Washington, DC.


CHAPTER 8

Chapter 8 Golden Growth In September 1961, an American professor named Edmund Phelps published a paper that proposed a simple rule for a nation’s wealth to grow and provide the highest standard of living for its citizens, present and future.1 Phelps called it “The Golden Rule” of economic growth. At around the same time, Carl Christian von Weizsäcker, a young German economist, submitted a doctoral dissertation proposing the same tenet.2 The golden rule essentially specified how much people had to work, save and invest today so that future generations were at least as well off as they were. The goal was to maximize consumption, but in a way that was economically sustainable. The rule implied that today’s generation should consume just enough—no more, no less—that their children would neither pity nor resent them. Phelps’ paper cited the work of three economists— from Great Britain, the US, and Australia—but the arguments built also on the insights of, among others, a Dutchman, a Frenchman, and a Hungarian.3 Fifty years later, the golden rule is still “the most basic proposition of optimal growth theory,” likely because it is simple enough for people to understand and appealing enough for policymakers to try to implement (Howitt 2007). The rule depends on many things, some that people and policymakers can choose or change more easily than others. It specifies how much goods and services people should consume given how hard they work. It depends on the size of future populations and is influenced by the pace of technological progress. And—though Phelps’ paper did not specify this—it is contingent on how much the country could sell and lend to others, and how much it could buy and borrow from them.

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Phelps wrote: “In deciding which growth path is best from its standpoint, a generation will look only at the amount of consumption which each path offers it. … Under conditions of natural growth, consumption along all these paths grows at the identical rate, g, so that these time paths of consumption cannot cross. Therefore, with resources limited, there must exist some uniformly highest, feasible consumption path. This dominant consumption path offers more consumption at every point in its history than any other natural-growth consumption path. All generations in such a history will naturally prefer this path, whence its corresponding investment ratio, to any lower consumption path. A rigorous demonstration is straightforward” (1961, p. 640). Incorrect choices meant that the growth path would not be at its optimum, and policymakers could improve the lot of current and future generations by influencing these choices. When consumption was above the optimal level and investment below that guaranteeing optimal consumption in the future, a tax on consumption to fund public investment or catalyze private innovation might help. Financing excessive consumption through foreign borrowing, by contrast, would hurt. If today’s consumption came at the cost of tomorrow’s environment, a tax on carbon emissions could help ensure a better future. The rule has implications for debates about broader economic welfare, not just economic growth narrowly defined.

Box 8.1: The structural prerequisites of a successful monetary union The eurozone has lower aggregate fiscal deficits and public debt as a share of GDP than the United States or Japan: as a whole, its current account is near balance. The eurozone’s problems are rooted not in aggregate imbalances, but in imbalances among member states. This report discussed returns to and responsibilities for greater integration in Europe. The policy implications speak directly to the structural prerequisites of successful monetary integration. Chapter 4 revealed how countries in the south failed to keep pace with productivity growth in the rest of Europe after monetary union, in part because of poor business regulation. Whether or not they entered the eurozone at an overvalued rate, their competitiveness problems have since been aggravated by poor policies. Prospective future euro members in the east should take note and fit their business environment for the euro. Chapter 6 showed that labor mobility is lowest and restrictions on hiring and firing are highest among the same Southern European economies that suffer most from a lack of competitiveness. Economic theory implies that countries with inflexible labor markets will struggle in a monetary union when faced

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with external shocks. The consequences of the 2008–09 crisis in the eurozone are now playing out as economists might have predicted. Labor market reforms are thus an important prerequisite for successful euro adoption. But this report shows that adjustment is possible. Chapter 7 indicated how countries can reduce excessive public debt without compromising the quality of public services. Adjustment is tough, and even the toughest adjustment will not suffice in Greece without an orderly restructuring of public debt. But countries such as Finland, New Zealand, Singapore, and Sweden show that a leaner government contributes to long-term competitiveness. Europe’s current debate over the fiscal union’s merits and risks masks the fact that Europe’s single market—more than fiscal transfers—is responsible for the convergence in living standards between Europe’s richer north and its poorer south, and more recently, between the west and the east. Whatever the solution European leaders arrive at, this feature of the European economic model should not be diluted or distorted. Crises of confidence in governments’ ability to meet debt obligations are not new. What

makes them special in Europe is that as eurozone members, countries cannot print money to meet domestic obligations. The common currency helped these countries during the global financial crisis of 2009; it may be hurting them in the sovereign debt crisis that followed in its wake. The fuzzy boundaries between solvency and liquidity complicate matters, as do concerns about moral hazard if deficit countries are bailed out. A break-up of the eurozone would be devastating for Europe as well as the world economy (for a summary discussion see Belke 2011). Countries with solvency problems should restructure their debts and close remaining public deficits through fiscal transfers conditioned on structural reforms. Governments have to be ready to intervene to recapitalize some banks, though the experience of Ireland discussed in chapter 3 should deter them from socializing all the losses. Sweden’s experience, discussed later in this chapter, shows how to do this better. Most solutions imply a loss of sovereignty for creditor and debtor countries in Europe. The findings in this book suggest that the benefits of European integration make this a price worth paying.


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Phelps and researchers after him have focused on an economy in “steady state,” a term that describes a condition that is neither a crisis nor a bubble. Few countries are in steady state these days. But the problem addressed by this research is as important today as it was in 1961, in the developing world as in the industrialized. And perhaps nowhere are the choices of people and policymakers more important for the economic growth and welfare of future generations than in Europe today. Appropriately, policymakers are now focused on the crisis in the eurozone. This report does not devote much space to possible remedies, except to point to the structural prerequisites of monetary integration (box 8.1). Europe faces structural challenges that today seem less urgent but may prove more difficult than those that a common currency created: falling populations; faltering productivity, especially in services; unsustainable social spending; and—in some places—a fraying work ethic. When the euro is stabilized, policymakers will ask questions posed by Phelps’ “growthmen”: what must Europe do to grow sustainably again? What changes must be made to the European economic model so that it returns to the golden rules of growth? This report applies these principles, which economists have developed over the last 50 years, to assess how to make European growth “golden.” The remedies are possible for a part of the world that is intrepid and inclusive. The recent experiences of countries that have succeeded in addressing these problems—in Europe and around the world—offer insights into these remedies. As part of the work commissioned for this report, 32 case studies were compiled, spanning 16 policy areas identified as important for European growth (table 8.1). For each of these policy areas—which range from managing financial inflows from abroad to providing social services at home—the case studies summarize the experience of

Table 8.1: Benchmark countries for selected policies Policy area 1

Restructuring private debt

Selected countries Europe

World

Sweden

Korea, Rep.

(EU) Poland

(Non-EU) Croatia

2

Managing financial foreign direct investment

3

Crisis-proofing financial integration

Czech Republic

Canada

4

Increasing value-added

Slovak Republic

Singapore

Ireland

New Zealand

5

Job creation

6

Export generation

7

R&D policy

8

Tertiary education

9

Management quality

10 11 12

Immigration policies

Germany

Korea, Rep.

Switzerland

United States

United Kingdom

United States

Sweden

United States

Internal mobility

Ireland

United States

Labor legislation

Denmark

United States

Sweden; United Kingdom

Canada; United States

13

Social security

Iceland

Japan

14

Social service delivery

Finland

Singapore

15

Reducing public debt

Turkey

New Zealand

16

Green growth policies

Germany

California (US)

Source: Iwulska (2011), available at www.worldbank.org/goldengrowth

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a pair of countries, one in Europe and one outside. Europeans should learn from one another, because some countries show how the European economic model can work well. Europeans should also learn from the Americans and Asians, whose governments have been facing similar tests and trials.

More Europe Not all 45 countries covered by this report are in the European Union, but they share the aspirations summarized in the European Union’s growth strategy, Europe 2020: economic development that is smart, sustainable, and inclusive. In seeking all three at once, European aspirations seem higher than those in other parts of the world. Europe’s way of life—and its growth ambitions—seem to put a higher premium on combining economic dynamism with environmental sustainability and social cohesion. Some countries in Europe show that achieving these objectives is possible. Europe 2020 is a realistic vision. To make this vision a reality, Europe’s growth model needs to be adjusted, not abandoned. This is the central argument of this report for three main reasons: · First, Europe has many attractive features that should be preserved. The economic model facilitated economic convergence, which helped 200 million Europeans escape the “middle-income trap” in the two waves of southern and eastern enlargement. Nearly another 100 million in southeastern Europe and Turkey could follow over the coming decade, and perhaps another 75 million in the eastern partnership countries afterward. Vigorous trade and financial flows, and growing exchanges of services and labor—all facilitated by pan-European institutions and infrastructure—enabled this convergence. · Second, Europe’s most innovative economies show that economic dynamism need not be the price for more equal societies with attendant sizable governments. Finland and Sweden show that large governments can be run efficiently. Denmark, Germany, and the Netherlands demonstrate that labor markets offering more security than those in the United States or East Asia need not be inflexible. Ireland and the United Kingdom show that AngloSaxon attitudes toward education and enterprise are compatible with the European social market economy. These examples might be exceptional, and for many European countries with weaker institutions, reducing the size of government could be easier than making it more efficient. But European companies compete successfully with their less regulated American or Asian peers, benefiting from the advantages of European integration. And as spotlight two highlights, Europe leads the world in green technologies, thanks to political will and regulatory foresight. · Third, changes in the European growth model must lead to more Europe rather than less. Strengthening the Single Market for Services would boost Europe’s growth, helping also to surmount barriers to world class innovation clusters in Europe, particularly in industries such as ICT, biotechnology, and health equipment and services. A continuing push toward deeper European integration would extend European finance, the benefits of trade, and the credibility of European regulations to emerging markets in the neighborhood. It would spur structural reform in both Europe’s economic core and its

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periphery, as it will be ever clearer that integration’s benefits will accrue disproportionately to countries that make their people and enterprises better suited for a Greater Europe.4 As European societies accept and act on the reality of aging populations and demographic decline, Europe’s appeal as a caring society will make it more competitive in the global market for talent. The 45 countries covered by this report have—to differing degrees—three assets: the European Union’s single market, momentum for regional integration, and Europe’s considerable global economic influence. Europe should play to its strengths by investing in these assets and reaping the returns. Growth will be the natural outcome of measures to do the following: · Deepen the single market, perhaps the European Union’s biggest achievement and its most valuable institution but one which, like the euro, “is unfinished business” (Almunia 2008). · Expand regional economic integration, a goal with a consensus unprecedented in European history and unequaled in the world today. · Strengthen Europe’s global economic leadership. A region that generates a third of the world’s annual output does not have to relinquish this position. This chapter concludes the report, pulling together the lessons from earlier chapters by matching policy priorities in each principal activity—trade, finance, enterprise, innovation, work, and government—to these three objectives. Chapter 1 shows how these activities are organized uniquely in Europe. To analyze intra-Europe differences in these components of the growth model, chapters 2 through 7 separate them somewhat artificially. Because they are interrelated, however, this chapter recognizes these relations, and collates policy priorities. This chapter makes explicit what is needed to address the three tasks Europe has to get done: get the most of the service economy; close the two productivity gaps that have opened between the EU15 and the United States, and within the EU15 between the north and the south; and adjust to demographic changes and an aging society. This chapter identifies what needs to be done, using the experience of successful countries in Europe and elsewhere to suggest how these changes can be made. Europeans want growth to be smarter, kinder, and cleaner. It is common sense that to accomplish this, Europe should build on its uncommon strengths—the single market, regional integration, and its global economic heft. The findings in chapters 2 through 7 identify the most effective measures for reviving and sustaining European growth (table 8.2). To make the single market more efficient, they focus on the trade in services, which requires facilitating the trade in digital services and harmonizing regulations across countries, and labor mobility within the European Union. To realize the benefits of greater European integration, the European Union’s existing members and its candidate and neighborhood countries have to expand production networks, attract foreign investment, and better manage financial linkages. They also need to reform public services and labor markets to stay fit for an integrated Europe. To maintain Europe’s global leadership it will be necessary to attract global talent, create world class innovation systems, address public sector debt, and reform social welfare systems to make public finances sustainable.

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Making the single market more efficient The single market is one of the European Union’s biggest achievements, justifiably called its “crown jewel.” Since its introduction in 1992, it has helped make Europe a trade powerhouse. As highlighted in chapter 2, of the $10 trillion of the global goods trade, $4.5 trillion involves Europe, more than Asia and North America combined. Europe also accounts for more than half the global trade in services. Although services account for almost three-quarters of total value added, Europe’s trade in services is only around $2.25 trillion, about half of the value of trade in goods. Chapter 2 measures European services trade against that of Canada, a unified national market with two main languages (and where, as in Europe, language barriers limit the tradability of personal and business services). It finds that the services trade could double or triple in the coming decade if barriers resulting from imperfections in the single market are removed.

Facilitate trade in modern services Chapter 2 shows that the potential for services trade remains most underexploited in modern services, such as finance, communication, licensing, computing and information, and other business services. While Europeans can travel freely, European doctors, architects, and designers cannot freely offer their services outside the country where they obtained their professional license. When Europeans fly across the continent, it matters little which country they purchase the ticket in; but when they telephone or use broadband Internet to communicate with other European countries, the charges for cross-border communication services differ greatly depending on who calls whom. European airspace is open and competitive; Europe’s railways are not. Certain digital services such as Spotify or iTunes are not available in every EU member state. National regulations are insufficiently harmonized across Europe, imposing barriers to services trade. The solution is mutual recognition across the single market. Service providers registered in one EU member state should be allowed to operate across all. Professional and education certificates obtained in one EU country should be recognized in others. Moreover, even when the European Union has hesitantly begun to harmonize services regulations, such as through the Service Directive, implementation has often lagged. A good example of regulatory harmonization is the European Union’s financial market directive, Markets in Financial Instruments Directive, which essentially requires all EU members to recognize banks and nonbank financial institutions licensed in one EU country, allowing the institutions to operate in their home market. But the example of financial services illustrates another policy challenge: the provision of services across borders requires closer coordination between home and host regulators. In the case of multinational banks, the European Union needs mechanisms to decide who bears the cost should they get into trouble. The efficient regulation of services across the single market thus requires European countries to relinquish sovereignty and accept collective liability. What is difficult in finance has yet to be considered in telecommunications, energy, and transport. But the benefits of strengthening the single market in all these services arguably far outweigh the loss of national regulatory authority.

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Table 8.2: Europe’s imperatives, instruments, and policy priorities Instrument

Imperative

Coverage

Modern services

Productivity growth

Deepen the single market

EU27

· Facilitate trade in digital services · Increase internal labor mobility

Widen regional economic integration

Europe 45

· Crisis-proof financial flows in Europe

· Facilitate production networks · Align business regulation with a common market · Improve public service delivery

Strengthen global economic leadership

Global 70

· Address private debt overhang

· Create world class innovation systems · Expand private funding of tertiary education · Reform (external) immigration policies

Demographic trends

· Reassess employment-protection laws · Reform social security · Reduce fiscal deficits and public debt

The barriers created by inadequate harmonization of national regulations, which restrict services trade and modern business services, matter already and will bind economic growth even more in the future. According to van Ark, O’Mahony, and Timmer (2008), about two-thirds of Europe’s productivity gap relative to the United States can be accounted for by the productivity gap in services. Chapter 2 demonstrates the positive link between the increasing size and sophistication of services trade and economic growth. But many services will remain nontraded, so the emphasis should be on creating the conditions for productivity growth in service sectors. Chapter 4 outlines what needs to be done to unfetter enterprise. And chapter 5 traces Europe’s lack of young, highly innovative firms in innovation-intensive sectors (such as ICT, health care, and biotechnology) to market fragmentation and the limited ability of innovators to benefit from the single market’s economies of scale. Some estimates put the benefits of completing the single market for digital services alone at 4 percent of the European Union’s GDP—or about €500 billion every year.

Increase labor mobility Labor mobility relates closely to trade in services. Many services require the movement of natural persons, while greater trade in services involves movements of workers within the European Union. While Europeans are half as mobile as Americans, they are not instinctively averse to moving—some such as the Irish are among the most mobile in the world (box 8.2). The young and better educated are more likely to move, and the share of European citizens residing in a country different from the one where they were born has increased by more than 40 percent since 2001.5 More can be done. Language and cultural differences in Europe contribute to natural barriers to greater labor mobility. But there are also policy-induced barriers, most important in the housing market and in social benefits. Most of the old EU member states restrict the movement of workers from new member states, though these restrictions are being gradually relaxed. The recognition of professional certificates is not complete, and some professions still require national licenses. Housing markets in many European countries can be

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Box 8.2: Internal mobility: Ireland and the United States Ireland The Irish are the most mobile of all Europeans. Internally Dublin is the preferred destination; regionally the United Kingdom; and globally the United States, where more than 10 percent of people claim Irish ancestry. The reasons the Irish are mobile span culture, geography, and labor laws. First, the Irish have reacted to big developments by moving, and their cultural proximity to the United Kingdom and the United States has made them prone to leaving when times are tough. Second, Irish labor laws make it easy for enterprises to hire and fire workers: indices of economic freedom rate Ireland the freest economy in Europe and the fifth freest in the world. Third, the national development strategy—including the use of cohesion funds—has promoted concentration around Dublin and made workers mobile by

investing in their skills. Fourth, Ireland has kept barriers to immigration low. It did not impose quotas on workers from new member states. And the quantity and quality of immigration is high—in 2008 nearly half of all immigrants had tertiary education. The mobility of the Irish will help them deal better with the economic crisis. United States Labor mobility is much higher in the United States than in other developed countries. Over the past decade, three times as many Americans moved to find jobs and better lives than Europeans. On average, an American moves 11 times during his or her life. The reasons span culture and policy. The country’s culture was built through immigration. Americans consider mobility as an essential ingredient to the pursuit of a better life. It also

reflects policy, as housing and labor market regulations make housing turnover easier than in other countries, allowing workers and employers flexibility. This mobility has direct and indirect costs: young Americans often live far from their families, and workers enjoy fewer protections than those in other developed countries. But they also benefit from the ability to negotiate wages, change employers quickly, and start businesses. Countries seeking to create jobs, nudge people back to work, increase earnings and economic growth, and make their economic structures more flexible should look at how the U.S. policy environment has supported labor mobility. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth

inefficient, making moving expensive. Zoning restrictions limit the supply of new housing, and the significant protection offered to long-term renters in many European countries segments rental markets, penalizing mobility. The transaction costs of buying or selling a house can be high, while property taxes tend to be low, to the benefit of existing owners. In addition, despite measures to ensure the portability of social benefits, including pensions and unemployment insurance across the European Union, it is limited in practice because of cumbersome implementation mechanisms, reducing mobility. And generous unemployment benefits in some European countries may discourage workers from seeking jobs in others. Collective bargaining agreements that limit territorial wage differentiation mute signals from the labor market. Reducing policy-based barriers to mobility is challenging: many Europeans worry that greater mobility will increase competition for scarce jobs. Such fears are misguided. Labor mobility may create new jobs—evidence does not support the idea that there is a fixed amount of labor to be shared among incumbents and newcomers. While greater mobility will make jobs more contestable—potentially creating pressures for those insufficiently skilled to benefit from new economic opportunities—more mobility will largely lead to more and better jobs. Given that Europe’s workforce is declining, employers and workers should welcome this. Europeans are generally ready to move; European leaders need to build on this to foster a new social consensus around a more mobile Europe.

Expanding regional economic integration The story of European trade and financial integration is remarkable. This report celebrates the achievements of economic integration, productivity growth, and increasing global competitiveness among Europe’s newest member states in the east. At the same time, chapter 4 notes how the European Union’s old members

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have not benefited equally from enlargement. Europe’s southern economies in particular have failed to make their companies fit for a larger Europe due to poor business regulation. Easy finance masked these shortcomings for a while, but the crisis exposed the risks of a three-speed Europe. European integration needs to be crisis-proofed.

Crisis-proof financial flows in Europe A unique feature of European integration is the large volume of financial flows from parent banks in Western Europe to subsidiaries in Central and Eastern Europe—a phenomenon we called “financial FDI.”6 As chapter 3 shows, financial integration is an enviable opportunity for Europe, but with tail risks. Countries that benefit from this opportunity adopt robust macroprudential regulations to moderate the credit booms that large foreign capital inflows induce. The policy arsenal includes capital and liquidity requirements, well-calibrated risk weights, and constraints on lending growth or forex lending. Regulations can also enhance credit quality by tightening eligibility criteria or loan-to-value and debtservice-to-income ratios. But chapter 3 also highlights the limits of such policies in an integrated financial market, and recommends advancing supranational coordination: supervising financial institutions operating across borders, managing liquidity risks during crises, and setting appropriate prudential regulations tailored to country-specific risks. Poland, among the European Union, and Croatia, among non-EU countries, show the benefits of a well-managed financial foreign direct investment (FDI). As the result of integration into the international and regional economy, Croatia and Poland experienced large inflows of financial FDI. Poland shows how good regulations and sound macroeconomic management can work with informal ways of keeping currency mismatches in bank lending manageable. Croatia shows the pros and cons of a more rules-based macroprudential regime (box 8.3).

Box 8.3: Managing financial foreign direct investment: Poland and Croatia Poland As with any type of capital inflow, governments must balance encouraging financial foreign direct investment and managing macroprudential risks. After joining the European Union in 2004, Poland succeeded in striking this balance. Several factors helped. First, good macroeconomic performance: output has grown for 20 consecutive years, and growth has averaged more than 4 percent since 1991. Inflation was brought down gradually and kept low for more than a decade. Second, Poland’s prudential banking sector regulations were relatively sound: capital adequacy trigger ratios are higher than the Basel Accord minimum, and banks must comply with binding liquidity standards. Moreover, Poland was among the region’s first to regulate foreign currency lending through Recommendation S in 2006. Third, an informal

yet effective approach to regulation by the central bank: much of the macroprudential regime, such as Recommendation S, was enforced through moral suasion, without automatic punishment mechanisms for noncompliance. This informal approach may have worked because of Poland’s generally sound macroeconomic policies. Croatia The foreign ownership of banks jumped from 7 percent in 1998 to 90 percent in 2002, remaining around this level since. Credit grew, especially for households. Between 2000 and 2008 household loans grew at an annual average of 23 percent. But with rulesbased macroprudential measures, Croatia managed the boom and subsequent crisis of 2008 relatively well. Between 2008 and 2010 banks enjoyed the highest average bank

regulatory capital to risk-weighted assets in the region. The ratio of nonperforming loans to total loans is around 7 percent. What lies behind this performance? Croatia successfully implemented rules-based macroprudential policies. The exchange rate regime largely ruled out the use of monetary policy. Large structural budget deficits reduced the potential for fiscal policy. Croatia’s formal prudential policy framework may have made up for weaknesses in macroeconomic management. This approach is not without drawbacks. It is difficult to limit credit expansion effectively and tailor policies to different sectors without creating distortions in the market. Restrictions on bank credit, for example, hampered the expansion of small banks. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth

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Recent developments cast a shadow over the success of financial FDI in Eastern Europe. In shoring up their balance sheets to deal with losses in Southern Europe, some western banks may decide to deleverage sharply or even leave Eastern Europe. Coordination between home and host bank regulators thus remains important. Under the “Vienna Initiative” in 2008–09, a combination of liquidity support from the European Central Bank, moral suasion by regulators, equity and subordinated debt injections, and stabilization facilities by international financial institutions encouraged western banks to stay. Similar efforts may be needed in the future. But the crisis in the eurozone also points to the need for greater supranational financial regulation. Supranational regulation would not absolve national governments from their responsibility to crisis-proof their economies and protect them from the risks of excessive credit growth. The Czech Republic and Canada built on good macroeconomic management to benefit from financial integration, without suffering from its excesses (box 8.4).

Facilitate production networks and FDI Chapter 4 shows how success in attracting FDI is correlated with the variation in productivity growth rates across EU12 countries. FDI has been good for Europe’s advanced countries too. Eastern European subsidiaries help their Western European parents remain profitable. Productivity and growth among firms with an international presence were significantly higher in all of the EU15’s old members. In France, average labor productivity among international firms was $149,000 against $70,000 for firms without an international presence, and productivity growth was four times faster. The creation of production networks between east and west following the fall of the Berlin Wall has been a boon to both sides, with Germany, Austria, Sweden, Finland, and their eastern neighbors in the Baltics and among the Visegrad countries (Poland, Hungary, the Czech Republic, the Slovak Republic, and Slovenia) as the biggest winners. The policies required to attract FDI are well known: efficient regulation and transparent, predictable, and enforceable rules, complemented by public investments in infrastructure and human capital. Yet, many of Europe’s neighbors to the east seem unsure of FDI’s benefits, keen instead to promote their own international champions. Ukrainians, Russians, and Kazakhstanis often point to the lack of domestic business groups of international scale in the new member states as a disadvantage, touting the benefits of home-grown world champions. Evidence suggests otherwise: Europe’s eastern neighbors remain wedded to a commodity-based pattern of comparative advantage. In 1991, Ukraine and Poland started from comparable relative productivity. In 2009, after 20 years of transition, Ukraine’s average productivity in purchasing power parity terms was a third of Poland’s.

Regulate enterprises for a greater European economy Eastern Europe’s success in attracting FDI and catching up with productivity in the European Union is striking. Similarly striking is the failure of Southern Europe’s enterprises to keep pace with productivity growth in the north and center. Chapter 4 documents the resulting “three-speed union.” The wheels of

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Europe’s convergence machine ground to a halt in the south at the same time that they turned smoothly in the east. The failure of Greek, Italian, Portuguese, and Spanish firms to benefit from the latest phase of European integration makes their economies uncompetitive, while the possibility of correcting this deficit through devaluation is closed off within the eurozone. Making their companies fit for an enlarged Europe is a priority in the south—not just for their own economies but for the eurozone’s economic health. What is holding southern firms back? Chapter 4 offers two explanations. First, Southern Europe lacks firms of a sufficient size to effectively compete and benefit from European integration. Second, burdensome business regulations keep southern firms small by discouraging investment and growing the shadow economy. Competition from the shadow economy can drag potential valueadded leaders down, perpetuating the low productivity equilibrium. This has not prevented job creation in the south. But too many workers in the EU15’s south are employed in small enterprises with low average productivity. An average gross output per worker of around $40,000, including gross profit and depreciation, is not sufficient to attract a college graduate, so many young skilled workers stay away. The recipe to address the south’s productivity gap is straightforward: better regulation and more internationalization. Rigid employment legislation, cumbersome tax systems, and burdensome product market regulations all make Southern Europe uncompetitive. The last decade has seen a large number of countries make significant strides in improving their business climate. Among the European countries that have made the most impressive progress is the Slovak Republic (box 8.5). Countries looking to create value-added leaders might also look to Singapore’s experience for designing efficient and effective business regulation.

Box 8.4: Crisis-proofing finance: the Czech Republic and Canada Czech Republic Most believe that financial integration with the west made banking systems in emerging Europe more vulnerable to external shocks. Yet, banks in some countries such as the Czech Republic did better than others during the recent global economic crisis. In 2009, Czech banks recorded sound profits: return on equity amounted to 26 percent, and the return of assets stood at 1.5 percent. This resilience reflected timely policy actions, a sound regulatory system, and prudent banking practices. First, the financial sector benefited from a consolidation program that the central bank initiated in the mid-1990s, closing many small banks. Second, the process of financial sector prudential oversight was also consolidated. Since 2005, the Czech central bank has had the authority to oversee all segments of insurance markets and

commercial and investment banking. Third, the banking sector has a strong retail deposit base and benefited from prudent lending practices— nonperforming loans were lower in the Czech Republic than in other Central and Eastern European economies. No country is crisisproof, but Czech financial sector practices and policies have been a source of stability during the financial crisis. Canada Canada’s banking sector survived the 2008–09 crisis without a taxpayer-financed bailout, and its banks remained stable and well capitalized. What did Canada do right? First, heading into the crisis, the structure of bank funding was favorable, as banks relied much more on depository funding than wholesale funding. Second, the country has one of the most restrictive capital adequacy standards in the world in risk-weighting, allowable capital

deductions, and definitions of permissible regulatory capital. Third, the structure of the banking system has traditionally made the sector more stable. Heavy regulation and tight restrictions on entry led to a highly concentrated banking system dominated by five large competitors. While this system made the sector less competitive, it also made the sector easier to regulate, limiting the size of the shadow banking sector. Supervisors always face a tradeoff between competitiveness and stability—the “regulator’s dilemma.” The performance of the economy before the crisis—annual GDP growth rates ranged between 2 and 4 percent during 1999–2008—and of the banking sector during the crisis suggests that Canada has struck the right balance. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth

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Improve the quality of public services Many countries in the western Balkans or the eastern neighborhood face the unenviable combination of large and highly inefficient public sectors. The same is true to a different degree in Europe’s south and among some core EU member states. Improved public services are key ingredients in the policy mix to make Europe’s periphery fit for competition in an integrated market. More efficient public services are also critical for fiscal consolidation and creating fiscal space for public investments. A vast repository of European and global experiences shows how to improve the quality of public services. This report highlights three key lessons. First, adjusting structures and staffing levels to demographic developments in education and health services can offer a considerable scope for cost savings. For instance, adjusting the number of schools and educational staff to demographic developments could save between 1.1 percent of GDP in the EU12 and 0.7 percent in the south. Resistance from staff, parents, and patients can be overcome if savings are partly reinvested in quality improvements. Second, improvements in education and health sector outcomes often result from selected public investments, greater autonomy for service providers (in some cases allowing competition between public and private sector providers, even with full public funding), and improved accountability through transparent performance criteria and public monitoring of performance. But country experiences have varied considerably. In Singapore, for instance, quality education outcomes were achieved in a centralized system with close quality monitoring and performance-

Box 8.5: Value-added leaders: the Slovak Republic and Singapore Slovak Republic The Slovak Republic is the European valueadded leader, increasing value added by 2.8 percent annually between 1995 and 2009. At independence in 1993, Slovak manufacturing was oriented toward heavy industry, but it was able to quickly diversify. First, productivity growth was possible due to employees moving from farms to high-growth manufacturing and services. Second, exporting enterprises in medium- and high-tech manufacturing industries were able to add value through new solutions: Slovak companies produced the second-highest number of export discoveries in chemicals, and third-highest in animal products and raw materials in the region. Third, perhaps the biggest part of the story has been FDI, which grew from negligible amounts in the late 1990s to more than 10 percent of GDP by 2010. Good policies encouraged this investment through a stable macroeconomic environment, targeted tax incentives, and a good business climate—which scored 41st in the World Bank’s Doing Business in 2011, including top marks for new business

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registration. Fourth, unit labor cost growth has been more moderate in the Slovak Republic than other Central and Eastern European economies: in 2006, the minimum monthly wage in the Slovak Republic was €181, lower than €223 in Poland, €230 in Hungary, and €280 in the Czech Republic. With its flexible factor markets and supportive policy environment, the Slovak Republic may remain a European leader in value added for some years to come. Singapore Singapore is a world leader in international trade and investment. A poor country in the early 1970s, it now has the 12th-highest GDP per capita in the world ($43,324 in current dollars in 2010). Manufacturing’s share in GDP rose from 14 percent in 1965 to 24 percent by 1978. In the 1990s and 2000s, manufacturing moved toward high-value-added sectors, and services became more predominant. This change has been the result of a development policy combining a free-market approach with state intervention. Singapore was able to

attract multinational corporations, promoting investment and knowledge transfers as a result of stable macroeconomic conditions, efficient infrastructure services, and a supportive business environment. The country is a research and development center, topping the World Bank’s Doing Business rankings in 2010 and 2011. The state invests heavily in education and R&D. In 2007, nearly a quarter of the labor force had a tertiary education. The National University of Singapore was 34th in the Times Higher Education World University 2010 ranking, and Singapore scores in the top three in the TIMSS assessment measuring students’ performance in mathematics and science. The Economic Development Board focuses on attracting foreign investment and cooperates with other agencies such as human resources for specific industries. Heavy state intervention can sometimes cause inefficiencies. But Singapore’s combination of institutions, infrastructure, and interventions has rapidly augmented its value added. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth


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Box 8.6: Public service delivery: Finland and Singapore Finland Finns are well educated, but spend less on education than most other Organisation for Economic Co-operation and Development (OECD) countries. They live healthy lives, on average five years longer than the typical European. In 2010, Newsweek named Finland the best country to live in. How does Finland deliver high-quality social services at reasonable cost? The government uses a “citizens as customers” approach that minimizes layers of bureaucracy between users and public decisionmakers. The education system is decentralized, with municipal funding and schools that are responsible for daily management. Students are encouraged to engage in self-assessments and take charge of their learning schedules. Teachers are free to plan their classes and choose textbooks. There are no national tests,

so teachers are responsible for measuring the results. Health care services are lean and decentralized, with municipal governments responsible for their delivery. Since 1990, the government has introduced several measures, such as user charges, to limit public spending on health care. And since 2006, “citizen’s offices” have improved communications between society and government. Singapore Singapore delivers high-quality public services at low cost. Government involvement in education and health care produced worldleading systems at public spending well below other high-income economies. Spending on education is less than 3 percent of GDP and health care spending is below 2 percent. The centralized education system produces top outcomes: Singapore scores in the top three in the TIMSS assessment measuring student

performance in mathematics and science, and in 2009 was ranked 6th in the OECD PISA test to assess reading, math, and science (OECD 2010). The government creates strong incentives for performing well in national tests, and plays a direct role in hiring world class teachers. Singapore also has one of the most inclusive and efficient health care systems in the world. The system ensures universal coverage in a cost-effective way through compulsory savings and price caps, with mostly private sector provision. Life expectancy is 81.4 years, and child mortality is one of the lowest among the OECD countries, at just 2.2 deaths per 1,000 live births. Singapore’s efficient and effective systems show that it is possible to have high-quality social services without straining the treasury. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth

based incentives for teachers and schools (box 8.6). Finland, by contrast, has little centralized quality control, emphasizing community-based accountability and investing in raising the professional recognition and qualification of teachers. In health care, successful quality improvements have typically involved a move toward public contracting with private health care providers, with output-based performance targets and user charges to encourage responsible patient behavior. Health systems are only starting to adjust to the challenges of aging. Europe faces the challenge and opportunity for genuine global leadership in this field. Third, the quality of public services is generally a function of public sector governance. Lack of trust in the state and a culture of administrative corruption hamper public sector performance in the east and south. Social trust is difficult to create, though in countries such as Estonia aggressive deregulation, administrative simplification, and the use of ICT to facilitate access to administrative services have greatly improved perceptions and performance of the government. The general lesson for countries not endowed with traditions of civic-mindedness and social trust is that government should either be run well or kept small.7

Strengthening Europe’s global leadership In 2010, Germany lost the export world champion title to China. Yet, for a country with a population 13 times smaller than China’s, and 4 times smaller than the United States’, topping the world export table for much of the past decade is a remarkable achievement. It epitomizes Europe’s success as a trade powerhouse. Other countries in Europe such as Austria, Luxembourg, Switzerland, and four Visegrad countries (the Czech Republic, Hungary, Poland, and the Slovak Republic) also do well in exporting. But many European countries have struggled to grow global leaders, and are pressured by their economic ties with dynamic neighbors.

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This struggle is most starkly reflected in the imbalances within the eurozone. Europe’s laggards need to learn from its export leaders. Europe’s prosperity, not reduced competitiveness of its world champions, will require its laggards to become more competitive. Global export leaders such as Germany and the Republic of Korea have used a common set of ingredients. These include increasing the economy’s ability to continually shift toward higher value-added activities and foster trade integration with neighboring countries so as to move fewer skill- and capital-intensive activities offshore. Stable finance (or in Korea’s case, rapid private debt resolution) and responsible business and employment regulation have helped. And, in both countries, the profits generated were reinvested in R&D (Iwulska 2011). The need to keep an eye on the long term and adapt to rapidly changing global markets may be the most important lesson for aspiring export champions.

Reassess employment protection legislation Labor market reform is among the toughest tasks facing such countries as Greece, Italy, Portugal, and Spain. The high cost of hiring and firing makes their economies inflexible, less able to react to shocks. It keeps people not in the labor force out of work, including the young, reducing aggregate productivity and fomenting social protest. Eastern European policymakers should take note. On employment legislation, many countries in the east lag far behind the EU15’s two decades of labor market reform. Lower unemployment, greater worker productivity, and higher labor force participation among the young all lead to more flexible employment legislation, as the experiences of Denmark, Germany, the Netherlands, and others demonstrate. Ideally, these outcomes should be combined with reductions in the tax wedge between gross and net earnings, well-designed unemployment benefits, and active labor market programs.

Box 8.7: Labor legislation: Denmark and the United States Denmark Every year, about 20 percent of Danes lose their jobs. But they don’t lose their income. Unemployment benefits replace close to twothirds of their earnings, and the government helps them find work. The arrangement seems to work well. Between 1995 and 2008, unemployment averaged 4.9 percent, compared with 8.5 percent in the rest of the EU15. How does Denmark have both flexibility and security? First, a tradition of productive industrial relations: in the Danish system, labor and trade unions, not the government, pay unemployment benefits. Second, sensible adaptation: the arrangements were reformed in the 1990s after decades of high unemployment. Policies cut job protection, raised unemployment benefit coverage, and strengthened job search assistance and training. Unemployment fell from 10 percent in 1993 to 3.3 percent in 2008, and long-term

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unemployment fell from a third of the total to a tenth. Third, generous public spending: Denmark spent 4.5 percent of GDP on labor market programs in 2008, a good year. The Danes have “flexicurity” because of their history, and they can afford it because of participation rates of more than 80 percent. Others who want both flexibility and security should be mindful of this. United States Between 1995 and 2010, average unemployment in the United States was 5 percent, about half the eurozone’s average of 9.4 percent. Labor participation rates are higher in the United States, anchored by a society that values work, flexibility, and competition. Employees can be hired or fi red fairly easily—employment protection in the United States is the lowest in the Organisation for Economic Co-operation and Development

(OECD). Labor taxes are low: the tax wedge on labor of 30 percent is among the lowest in the advanced world. Unemployment benefits are lower than in most European countries while net replacement rates for the long-term unemployed are the second-lowest in the OECD. What are the pros and cons? On the whole, the system succeeds in delivering jobs and productivity growth. Firms and workers have more freedom to negotiate contracts that suit their needs. States and municipalities can add programs that their voters want and their local economies can afford. Countries seeking to promote productive employment would do well to look to the United States for ideas. But the absence of a universal health care system in the United States means that most Americans need a job if they want good health care. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth


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Denmark’s “flexicurity” model combines relatively low employment protection with considerable spending on active labor market policies and generous unemployment benefits, achieving a coveted combination of generous social security for workers with flexible labor markets and low unemployment (box 8.7). But these expensive policies rely on the capacity of labor offices to place the unemployed rapidly into sustainable new employment—a tough task during a prolonged economic downturn. The United States has a more traditional model of high labor force participation, achieved through lower employment protection, flexible labor markets, and limited unemployment insurance benefits. Countries in Eastern and Southern Europe will need to decide whether to opt for the expensive but less socially disruptive Danish system or the rougher efficiency of American labor markets. At the moment many have neither.

Address the private debt overhang quickly While public sector debt is the focus of attention, a private debt overhang might drag down European growth. Chapter 3 shows that Eastern Europe’s enterprises and households—which absorbed a big rise in credit in the decade leading up to the 2008–09 crisis—generally are not overleveraged. This is not necessarily true of their counterparts in Southern Europe. And while banks in emerging Europe seem reasonably capitalized and have built adequate reserves against the increase in nonperforming loans, renewed economic uncertainty is cause for concern. A crisis of confidence would strain banking sector balance sheets, potentially causing a flight of deposits from some countries. What should governments do if this happens? Ireland, which nationalized its banking system and took on all private sector liabilities, tells a cautionary tale. Sweden and the Republic of Korea are better examples (box 8.8). Both quickly recapitalized financial institutions, limited taxpayer liabilities by sharing losses with the private sector, and put corporate debt restructuring frameworks in place to facilitate a rapid workout of nonperforming loans. The synchronized nature of the current instability may require more coordinated approaches to bank recapitalization, particularly for sovereign debt restructuring in the eurozone.

Create world class innovation systems Germany’s success in exporting cars and machine tools to all corners of the world should not distract from the fact that new industries such as ICT, biotech, and health and medical services are likely to play a key role in Europe’s growth prospects and international competitiveness. As chapter 5 argues, Europe does not do well in these high-growth, innovation-intensive industries, especially when compared with the United States, the global leader. Several factors determine the quality of a country’s innovation system. They include world class universities, developed venture capital markets, public procurement policies, and regulations that stimulate innovation and maintain strong competition. Denmark, Finland, Sweden, Switzerland, and—to less extent—Germany have copied these features and built innovation systems that compete with the world’s best (box 8.9).

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Box 8.8: Reducing private debt: Sweden and the Republic of Korea Sweden Sweden illustrates how to reduce private sector debt after a crisis. After the crisis in the early 1990s, the government not only revived the economy but also restored the health of household balance sheets. The ratio of debt to disposable income of Swedish households fell from 130 percent in 1989 to 90 percent in 1996. Interest payments were halved from 10 percent of disposable income in 1990 to 5 percent in 1997. The government kept the costs of the bailout low. By 1997, the total bill amounted to only 2 percent of GDP, due to a comprehensive program that was tailored to different classes of financial institutions and realistic about financial sector losses. First, the government quickly recognized these losses. Transparency and true valuations were conditions for government support. Because banks were forced to write down losses, markets received accurate information. The government guaranteed their liabilities or took an ownership stake in the bank. By 1992, the Swedish authorities owned nearly a quarter of bank assets. Second, the government adopted an approach that was sensitive to distinctions among classes of financial institutions. Government assistance was available to not

included in the government’s plan to restore solvency. Under government pressure, the country’s largest conglomerates negotiated debt workout programs with the banks. Government intervention led to the rollover of 90 percent of small and medium enterprise loans between July and November 1998, the worst months of the crisis. Nonperforming loans fell in part due to the government’s program to recapitalize healthier banks and merge or liquidate insolvent institutions. Second, new statutes allowed banks to go bust. The Korean Asset Management Republic of Korea Corporation was created to handle bad loans The Republic of Korea’s policies after and prevent “zombie banks.” Third, the size of the 1997–98 crisis show how quick and the government’s response was proportionate comprehensive intervention can reduce private to the crisis: financial sector support amounted sector insolvency and restart growth. Korea’s to 13 percent of GDP between 1998 and 1999. corporate and financial sectors were heavily Fourth, monetary policy managed deflation indebted when the East Asian financial crisis risks while participation in an International hit. A rapid-debt-reduction program brought the overhang under control. In manufacturing, Monetary Fund program and the introduction of central bank independence in 1998 sent the debt-to-equity ratio shifted from 396 strong signals to the markets. Timeliness, percent in 1997 to 211 percent in 2000. The broad scope, targeting, and scale of response share of nonperforming loans fell from more are all important in dealing with a private debt than 8 percent in 1999 to just below 2 percent overhang. in 2002. What can other countries learn? First, the policy response was comprehensive. Source: Iwulska (2011), available at www. All corporations, large and small, were worldbank.org/goldengrowth only Swedish banks but also foreign-owned subsidiaries in the country. And the support’s structure and amounts were tailored to the necessities of particular banks or institutions. A special body—the Bank Support Authority— was set up in 1993 to assess the magnitude of the troubled loans, as well as each bank’s earning potential in the long run. The actions of the Swedish government show the potential for public policy to address the fallout of a financial crisis, if implemented quickly with an honest recognition of financial sector losses.

Three basic lessons: first, governments should ensure that the table is properly set; no amount of incentives and targeted policies can compensate for a poor business climate or inadequate infrastructure. Second, public support should work through the market, stimulating private investment, not aim to substitute for market finance when profits are paltry. Finland’s matching grant scheme for early innovators, for instance, catalyzed private venture capital funding, and Israel built a venture capital industry with initial injections of public funds and foreign investment. Third, public policy can encourage linkages between innovators and businesses, and help scientists expand their international collaboration—particularly in Eastern Europe, where national R&D institutions need to be thoroughly reformed. Yet, innovation in Europe’s frontrunners is held back by scale; Turku is not Tokyo and Zurich is not San Francisco. European markets for ICT, pharmaceuticals, and health services are not sufficiently integrated. Achieving global leadership in innovation will require more than world class national innovation systems. It will require a Europe-wide approach to create the necessary scale to match America’s and Asia’s dynamic innovation clusters. A good example of what holds Europe back is the lack of a single European patent, because EU member states cannot agree on the language requirements.8 An encouraging example is the pooling of public funding for excellence in scientific research at the European Research Council, with a budget of around €1 billion a year.

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Expand private funding of tertiary education As the tasks performed by Europe’s emerging economies grow more sophisticated, and the competition from middle-income countries in Asia intensifies, workforce education becomes ever more important. Europe lags Japan and North America in the share of the workforce with tertiary education, and within Europe, the east and south lag the center and north, both in the quantity and quality of higher education. Most European countries see higher education as a task for the state. Private funding is limited, private universities are the exception, and links between business and university-based research are weaker than in the United States. Europe’s tertiary education policies are designed to ensure equal access to higher education and to keep research free from corporate agendas. Yet, the approach must be questioned. High fees have not discouraged young Americans from seeking a higher education; wages for graduates are much higher than for those who leave school, offering a good rate of return on investment for a university degree. And it is not just Americans who are encouraged: U.S. universities have many more international students than most universities in Europe. Switzerland and the United Kingdom are the notable exceptions (box 8.10).

Rethink immigration policies In Europe, immigration policy is often seen as a humanitarian intervention. Many immigrants are refugees from countries with oppressive political regimes or civil wars, and Europeans—mindful of their own history of war and displacement— accept immigration as a moral duty. Family reunions are also an important part of European immigration. Many Europeans, however, would oppose more immigration for economic reasons: workers moving to Europe in search of higher wages, and employers inviting immigrants to fill positions with few local applicants for the wages offered.

Box 8.9: R&D policy: Switzerland and the United States Switzerland Switzerland is Europe’s leader in innovation. In 2007, it obtained the highest number of patents per capita among industrialized countries, roughly three times the Organisation for Economic Co-operation and Development (OECD) average. According to the Global Benchmark Report 2011, Switzerland is the most competitive country in the world, ahead of Canada, Australia, the United States, and Sweden (Confederation of Danish Industry 2011). The reasons? First, Switzerland started early. Its emphasis on research and innovation has a long history. The first two institutions funding university-based research were established in or soon after 1943. Second, there are strong public-private links in the funding and conduct of research, and Switzerland has more private spending. Swiss

expenditure on R&D was almost 3 percent of GDP in 2008, above the OECD average. Second, this spending is linked well to a broad tertiary education base: the United States accounted for a third of the total OECD population with higher education. Its universities can reap the commercial payoff of R&D, even when it is federally funded. Third, federal funding is not the sole driver of R&D and innovation: private firms spend a lot. The partnerships of venture United States capitalists and entrepreneurs in places like Half of the 50 most innovative companies in Silicon Valley have driven new innovations, the world, as ranked by Business Week in 2010, changing business and expanding the are American. The country dominates the technology frontier. Fourth, product market most R&D-intensive sectors. For example, it competition, labor market flexibility, and creates a third of the value added in the global substantial management talent increase the information and communications technology payoff to R&D spending. industry. How does the United States do so Source: Iwulska (2011), available at www. well? First, sizable public spending: gross worldbank.org/goldengrowth companies spend twice as much on R&D as the EU27 average (Switzerland spends 2.2 percent of GDP; EU27, 1.1 percent of GDP). Third, Switzerland has some outstanding universities: with a population of just 8 million, it has four universities in the top 100 of the Times Higher Education World University 2010 ranking. In part due to its R&D policies, Switzerland may be Europe’s most innovative country.

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Box 8.10: Tertiary education: the United Kingdom and the United States United Kingdom British universities are the best in Europe, with two or three regularly among the top 10 in the world. After the United States, the United Kingdom has the second-largest number of foreign students. Expenditures are around 6 percent of GDP, the Organisation for Economic Co-operation and Development average. How has the United Kingdom gotten exceptional results with an ordinary budget? It has done a better job than its neighbors in combining a rich European heritage with modern knowhow. First, spending per student is higher in the United Kingdom than most European countries. Second, universities charge high tuition fees by European standards, supported by student loans. Third, universities in the United Kingdom enjoy more independence from government. This creates greater

competition for funding and talent and more innovative curricula. The United Kingdom still faces challenges in getting the tuition cap right, supporting part-time students, and ensuring that schools are producing needed skills. But it has shown that it is possible to meld the tradition of great European universities with current needs and a modern approach. United States American universities successfully address two important issues: a growing demand for tertiary education, and limited capacity and public funding. A diversity of academic opportunities helps target different educational needs, while abundant funding and favorable governance allow top universities to attract world scholars, students,

and companies, channeling knowledge into ideas, innovations, and business solutions. Moreover, universities enjoy autonomy and diversity in funding, which is important in setting standards. U.S. universities dominate the international league tables, taking the top 5 positions—and 7 of the top 10—in the latest Times Higher Education World University ranking. Moreover, U.S. universities attract 20 percent of all international students. Given the role of top universities in building human capital for public and private sectors, and as direct and indirect contributors to innovation, other countries should look at how the United States regulates and finances its higher education systems. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth

As chapter 6 argues, this attitude toward immigration puts Europe at a competitive disadvantage with immigration-friendly countries in North America and Oceania. Immigrants are needed to compensate for the decline in Europe’s labor force, even with efforts to increase labor force participation and promote greater internal mobility. Europe should devise a more “economic” immigration policy. This should not imply that humanitarian motives for Europe’s immigration policy are wrong. Instead, Europe should look at immigration as a gain rather than a gift. Ireland, Sweden, and the United Kingdom have immigration policies that reflect good practices in other parts of the world, such as Canada and the United States (box 8.11). What are the ingredients? Nondiscriminatory labor markets attract the best and brightest. Language training for adults, access to education for immigrant children, and the prospect of acquiring citizenship all facilitate integration into society. “Points” systems can filter immigrants with required skills, and immigrants with job offers can be granted additional points. Opening universities to talented foreign students often attracts and retains a skilled labor force. A more conscious and proactive immigration policy could help Europe maximize economic gains while keeping social tensions low.

Reform social security Europe’s social security systems (public pensions, unemployment insurance, and social welfare) largely account for the bigger size of its governments. The pension system accounts for the bulk of social security spending. Keeping pension spending under control remains the most important task—not only for fiscal consolidation, but also to prevent payroll taxes from rising and making European enterprises uncompetitive in world markets. As chapter 7 demonstrates, pension reform has begun in parts of Europe. Pressed by markets, governments have increased the retirement age, abolished early retirement schemes, and encouraged private savings for old age and infirmity.

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Iceland appears to have achieved these objectives, maintaining a high level of old-age security (as reflected in generous replacement rates) at reasonable cost to the government. Japan’s experience should also provide encouragement: the fastest-aging economy in the world spends around 10 percent of GDP on its public pension system, less than France, Germany, or Greece (box 8.12). The average public spending on pensions is essentially the same as in Europe ($16,000 in 2000 prices). The main difference: the Japanese work longer, up to almost age 70 for men and more than 67 for women. Chapter 7 advocates the principle that social security spending should exceed 10 percent of GDP only in exceptional circumstances (such as those in Japan). Over the medium term, savings of around 1 percentage point of GDP must be found in Europe’s north, around 2 points in the center, and around 3 in the south. Serbia and Ukraine, with pension spending in excess of 15 percent of GDP, have more radical reform needs.

Reduce deficits and public debts Fiscal austerity has become the battle cry of European leaders as they try to restore confidence in the eurozone. For much of Europe, it is necessary. As chapter 7 demonstrates, fiscal discipline is not just needed to reassure nervous investors— it is required to restore long-term growth. During the 2008–09 crisis, there was a coordinated push by governments in the industrialized countries to adopt fiscal stimulus packages to stem the decline in aggregate demand and pull western economies out of recession. A more differentiated approach might have been more suitable then; it is definitely needed now. Large government is associated with slower growth in Europe. Even in the short term, expansionary government spending will not restore growth. But politically, achieving a lasting fiscal consolidation is not easy. A crisis such as that currently gripping the eurozone is an opportunity to muster the political energies to push through such a consolidation. Constitutional debt ceilings and “golden rule” provisions limiting new borrowing to the amount of public

Box 8.11: Immigration policies: Sweden and Canada (and the United Kingdom and the United States) Sweden (and the United Kingdom) Immigration plays a big role in both countries: in 2008, the foreign-born were 14 percent of Sweden’s population and 11 percent of the United Kingdom’s. Both have fairly liberal policies toward migrants from the new EU members, but they have different ways of assimilating foreigners. Sweden allows foreigners access to almost all benefits available to natives, setting clear rules on how to obtain citizenship. The United Kingdom’s appeal does not come from its migration policy. The country attracts highly skilled newcomers for a range of reasons: cultural diversity, low language barriers, metropolitan centers such as London, and the presence of

multinational companies. European countries need models to learn from in managing immigration. Sweden and the United Kingdom offer contrasting examples, but both have aspects that deserve study, adaptation, and even emulation. Canada (and the United States) As global magnets for talent, the United States and Canada are exceptional, for somewhat different reasons. The U.S. economy is powered by immigration, and more than a million people immigrate there every year. Canada also has one of the highest shares of immigrants: one of five residents is foreignborn. The quality of immigration is high in

both countries. But immigration policy differs in many ways. The United States attracts migrants through its size, its tradition as a country of immigrants, and its contestable labor markets and job opportunities. Of all the immigrants coming to the United States, more than a quarter have tertiary education. But the lack of a comprehensive policy can lead to undocumented migration and weak public institutions for integrating immigrants. Canada has a more comprehensive set of policies based on a “points” system to both meet labor market needs and reunite families. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth

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Box 8.12: Social security: Iceland and Japan Iceland Iceland may show a way forward for countries trying to meet social security promises while holding public spending in check. Its system delivers one of the highest replacement rates in the world—close to 97 percent for the average worker—at a low public cost of less than 2 percent of GDP, compared with the Organisation for Economic Co-operation and Development (OECD) average of more than 7 percent. It helps that, for a developed country, Iceland has a relatively young population with a high fertility rate. But there are other reasons. First, the system has had a pensionable age of 67 years for both men and women for several decades. Tax and other policy incentives encourage workers to stay in the labor force beyond the legal minimum, and the country has one of the world’s highest elderly participation rates.

Second, benefits are means-tested. Third, a mandatory occupational pension scheme must deliver more than 50 percent of replacement wages for workers meeting minimum tenure requirements. The pension system contributed to the development of Iceland’s financial sector and has already recouped most of the losses experienced during the country’s recent economic collapse. Japan Japan has the oldest population in the world. The ratio of Japanese ages 65 and older to the working-age population is 35 percent, compared with 25 percent for the EU15 and 20 percent for the United States. What is Japan doing, and what can aging countries learn? First, an aging society is a big fiscal burden, but it can be looked after by adjusting the system. Public pension spending in Japan is 10 percent of GDP, nearly 3 percentage points

higher than the OECD average. But Japan still spends less than younger countries: for example, the ratios are higher in France (13 percent), Greece (12 percent), and Germany (11 percent). The pension system has been adjusted several times: in 2004, for example, the government cut benefits for new retirees by 0.9 percent a year. Second, people have to work longer. Japan’s system punishes early retirement with lower benefits, and encourages later retirement with the lowest implicit tax on working beyond retirement age. Third, the elderly can be protected by making public pensions progressive, with lower replacement ratios for high-income retirees. Japan may need to do even more: female work participation could be much higher and Japan may need more immigrants. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth

investment can provide focal points for consolidation efforts. The European Union’s macrosurveillance framework provides for an annual reduction of public debt by one-twentieth of the difference between current debt and the Maastricht criterion of 60 percent of GDP. Using a 60 percent of GDP debt ceiling for the EU15 and a 40 percent ceiling for the EU12, the candidate countries, and the eastern partnership, chapter 7 calculates the required improvement in the primary balance to range between 3 percent of GDP (for the eastern partnership countries) and almost 8 percent of GDP (for the southern EU member states). For inspiration in matters of fiscal adjustment, European leaders might turn to Turkey—a country with repeated fiscal and external imbalances resulting in bouts of inflation and exchange rate instability. Since 2001, however, Turkey has stabilized public finance, rapidly reduced public debt, and enjoyed fast (if volatile) economic growth. The 2008–09 crisis left the country much less vulnerable than previous episodes. Turkey’s approach to fiscal stabilization and its economic reforms to boost competitiveness may have lessons for Southern Europe (box 8.13). New Zealand, where a crisis precipitated a reform of public finances and social service delivery, is another example.

Growth’s golden rules To conclude this chapter on the subject it began with, one can ask whether there are there any “golden rules” to guide policymakers to ensure the maximum consumption for Europe’s current generation, while keeping future generations’ prospects bright. The discussions around greater fiscal prudence, and the proliferation of constitutional brakes on public debt, suggest that governments in Europe are searching for a new set of rules. A set of golden rules for growth might look something like the following:

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Box 8.13: Reducing public debt: Turkey and New Zealand Turkey Turkey halved the ratio of public debt to GDP from almost 80 percent in 2001 to less than 40 percent before the global crisis of 2009. Several factors helped. First, global prosperity, reforms at home, and accession talks with the European Union spurred growth. Second, through greater fiscal discipline, Turkey generated primary fiscal surpluses between 2002 and 2005. Third, it granted more independence to the central bank and implemented better monetary policies, increasing the confidence of global markets in the lira. Fourth, it better managed public debt, leading to longer maturity periods and lower interest rates. And fifth, it prudently

used privatization proceeds to repay sovereign debt. It takes a lot to reduce public debt, but Turkey shows it can be done. Its neighbors in Southern Europe might learn by studying its debt management practices, monetary policies, and reform and privatization program during the 2000s. New Zealand Since the early 1990s, New Zealand has halved its public debt—from around 60 percent of GDP to 30 percent in 2010. The country led in fiscal prudence: it was second in Stanford University’s Sovereign Fiscal Responsibility Index rankings in 2010. What did it do? First, deep reforms in state finances helped return it to primary fiscal surpluses in 1994, after

two decades of deficits. The fiscal reforms were comprehensive: the government set up a management framework for a sustainable fiscal policy—using, for example, financial reporting standards similar to private sector accounting rules. Second, New Zealand used privatization proceeds of NZ$14 billion in 1988– 96 well, and made operations ranging from air traffic control to postal services competitive through deregulation. Third, these steps were part of a broader reform program that included reducing inflation from more than 8 percent in 1986–91 to 2 percent in 1992–97. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth

· Extend the benefits of freer trade to those outside the European Union. Enlargement has made Europe stronger, and Europe should continue to extend economic integration toward the east. Trade is the most important part of Europe’s convergence machine, and the single market is the European Union’s “crown jewel.” The European Union should strengthen the single market, and speed up the extension of its benefits to its neighbors. · Borrow from abroad only for investment. Where foreign finance has been used for private investment, it has fueled productivity growth and convergence in Europe. But countries relying on finance mainly to boost consumption have added less to productivity, becoming more vulnerable. Rules for countercyclical fiscal policy and macroprudential regulations follow. · Give enterprises the freedom to start up, grow, and shut down. Efficient regulation of enterprise should trust but verify, make compliance easy but punish violation, and concentrate regulatory resources where risks are highest. Regulation in Europe should promote competition by making entry and exit easier for enterprises, and should reduce the costs of running or growing a business. · Public funds should catalyze private innovation, not substitute for it. Effective innovation policy sets the table for innovators to thrive. It supports inventors, mobilizes finance, understands the importance of economic agglomeration, and brings choice and business resources into universities. · Labor laws should treat insiders and outsiders more equally. Regulations should not treat those who seek jobs and those who have jobs differently. Seeing labor as a fixed lump to be divided among workers leads to poor rules. Contestable labor markets, greater mobility within Europe, and talent attracted from outside will help Europe create jobs, make workers more productive, and help offset the demographic decline. · Public debt should mainly finance public investment. With high debt and modest expected growth rates in Europe, government spending should now be based on the premise that future generations are not likely to be a lot wealthier. Taxation

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should finance social security, public services, and the government wage bill. Efficiency considerations—not equity—should drive borrowing. With policies that reflect these rules, Europe can restore the lustre of its economic model. It can secure the welfare of the 500 million people who live in the European Union today. The European convergence machine can bring another 100 million people in Europe’s candidate and potential candidate countries to high-income status—and accelerate improvement in the living standards of 75 million people in the eastern partnership. There are many reasons to believe that Europeans will make these changes. The main reason for optimism is that many countries in Europe have already made changes, and others are making them. The sovereign debt crisis has obscured the fact that Europe has done quite well over the past two decades. As this book demonstrates, Europe excels at managing trade and most aspects of private finance. It has done reasonably well in regulating enterprise and promoting innovation, though with big differences across countries. Its weaknesses lie mainly in how it has organized work and government. But even in these aspects, some countries in Europe have rebuilt their institutions and can serve as models for others. A report card on Europe’s performance for the last two decades would be a solid “B.” Over the next two decades, with strengthened economic structures, better social policies, and efficient government, an “A” is not out of reach.

Answers to questions on page 433

Greater labor mobility and more uniform national regulations for modern business services are making the single market more efficient. Sustaining economic integration requires making the single market efficient, crisis-proofing financial flows, and facilitating production networks through improved public services in emerging Europe. To Europe h has T remain i a global l b l economic i lleader, d E to sustain regional integration, reduce public debt, reform social security, revamp employment protection laws, and institute policies to attract talent from around the world. 454


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Notes 1

Phelps, Edmund. “The Golden Rule of Accumulation: A Fable for Growthmen.” The American Economic Review, Vol. 51, No. 4. (Sep., 1961), pp. 638-643.

2

von Weizsäcker, Carl Christian. 1962. Wachstum, Zins und optimale Investitionsquote, Tübingen (Mohr-Siebeck), 96 pages.

3

They were Tjalling Koopmans, Maurice Allais, Christian von Weizsacker, and John von Neumann.

4

In an excellent account of the euro’s origins and prognosis, Marsh (2009, p. 194) cites an excerpt from a 1996 speech by former Bundesbank president Hans Tietmeyer: “In a monetary union, countries have to tackle and solve their economic problems and challenges in a similar way and with similar speed. If the countries decide fundamentally different answers, then great problems will arise. Countries which implement the right solutions soon become more competitive against those which react wrongly or late.” What is true of monetary union is also true for broader economic union. It is also sensible for those expected to join the eurozone to get a head start on reforms needed to make their economic structures more flexible.

5

6

Strictly, the flows from parents to subsidiaries include various forms of financing, and not all can be classified as FDI. There clearly is, however, a close relationship between the large equity stakes western banks took in Eastern Europe and their willingness to have large debt exposures to their subsidiaries in order to finance rapid expansion of their business. Many have acquired valuable franchises that are unlikely to be wound down. But some have come in late, or moved too aggressively into risky business areas, and may be forced to recognize losses and exit due to the need to shore up balance sheets back home.

7

World Bank (2012) discusses Georgia, where a legacy of poor public sector performance has begun to be overcome through radical simplification and deregulation, allowing the state to focus on essential tasks, pay public servants better, and reduce administrative corruption.

8

This is persuasively argued in the Report of the Polish Presidency of the Council of the European Union on rekindling economic growth in Europe (Ministry of Foreign Affairs of Poland 2011).

Labor mobility also improves the flexibility of labor markets and is associated with lower unemployment (chapter 6). By allowing workers to move to where jobs are and their skills are in highest demand, it increases aggregate productivity. Chapter 5 hypothesizes that despite progress over the last two decades, Europe’s labor markets are still too fragmented to allow leading innovation clusters such as Silicon Valley or Tokyo to emerge. Labor mobility would also help all European countries deal with their demographic challenges, by getting more of Europe’s young people and workers in structurally weak regions into work.

455


GOLDEN GROWTH

References Almunia, J. 2008. “The European Economy as Home to the Next Global Currency.” Keynote speech delivered at the conference jointly sponsored by the Peterson Institute for International Economics and Bruegel, The Euro at 10: The Next Global Currency?, Washington, DC, October 10, 2008. Belke, A. 2011. “Doosday for the Euro Area: Causes, Variants and Consequences of Breakup.” Report prepared for the Bertelsmann Stiftung, November, Bertelsmann Stiftung, Gütersloh. Confederation of Danish Industry. 2011. Global Benchmark Report 2011: Ready for Globalisation? Copenhagen: Confederation of Danish Industry. Howitt, P. 2007. “Edmund Phelps: Macroeconomist and Social Scientist.” The Scandinavian Journal of Economics 109 (2): 203–224. Iwulska, A. 2011. “Country Benchmarks.” Prepared for this report. Available at www. worldbank.org/goldengrowth. Accessed January 23, 2012. Marsh, D. 2009. The Euro: The Politics of the New Global Currency. New Haven, CT: Yale University Press. Ministry of Foreign Affairs of Poland. 2011. “Towards a European Consensus on Growth.” Report of the Polish Presidency of the Council of the European Union, Ministry of Foreign Affairs of Poland, Warsaw. OECD (Organisation for Economic Cooperation and Development). 2010. PISA 2009 Results: What Students Know and Can Do: Student Performance in Reading, Mathematics and Science (Volume I). Paris: OECD. Phelps, E. 1961. “The Golden Rule of Accumulation: A Fable for Growthmen.” The American Economic Review 51 (4): 638–643. van Ark, B., M. O’Mahony, and M. Timmer. 2008. “The Productivity Gap between Europe and the United States: Trends and Causes.” The Journal of Economic Perspectives 22 (1): 25–44. World Bank. 2012. Fighting Corruption in Public Services: Chronicling Georgia’s Reforms. Washington, DC: World Bank.

456


SELECTED INDICATORS

Selected Indicators TABLE A1. BASIC INDICATORS TABLE A2. TRADE TABLE A3. FINANCE TABLE A4. ENTERPRISE TABLE A5. INNOVATION TABLE A6. LABOR TABLE A7. GOVERNMENT SOURCES AND DEFINITIONS

457


GOLDEN GROWTH

Table A1. Basic indicators GNI, per capita, US$ 2010

Per capita, PPP, international $ 2010

GDP PPP, international $, billions 2010

Real, per capita, growth, percent 2000-10

Austria

47,060

40,005

335

1.3

Belgium

45,910

37,600

409

1.0

Denmark

59,050

39,489

219

0.6

Finland

47,720

36,651

197

1.9

France

42,390

33,820

2,194

0.7

Germany

43,110

37,260

3,044

1.2

Greece

26,940

27,805

315

2.0

Ireland

41,000

41,188

185

1.6

Italy

35,150

31,555

1,909

0.0

Luxembourg

77,160

86,899

44

1.8

Netherlands

49,050

42,255

702

1.2

Portugal

21,880

25,610

273

0.6

Spain

31,750

32,070

1,478

1.0

Sweden

50,110

39,029

366

1.8

United Kingdom

38,370

35,904

2,234

1.1

32,710

34,895

11

1.2

137,070a

1.0b

EU15

European Free Trade Association Iceland Liechtenstein Norway

84,290

56,692

277

0.9

Switzerland

71,530

46,581

365

1.0

Bulgaria

6,270

13,780

104

5.1

Cyprus

29,430

31,092

34

1.4

Czech Republic

17,890

25,283

266

3.1

Estonia

14,460

20,615

28

5.0

Hungary

12,850

20,029

200

2.4

Latvia

11,620

16,312

37

4.9

Lithuania

11,390

18,184

60

5.1

Malta

19,270

26,640

11

1.5

Poland

12,440

19,783

755

4.1

Romania

7,840

14,287

306

4.7

Slovak Republic

16,830

23,423

127

4.5

Slovenia

23,860

27,063

56

2.6

Albania

3,960

8,817

28

5.0

Bosnia and Herzegovina

4,770

8,590

32

3.8

Croatia

13,870

19,516

86

3.1

Kosovo

3,290

5.7

Macedonia, FYR

4,570

11,159

23

2.4

Montenegro

6,750

13,016

8

3.7

Serbia

5,630

11,281

82

4.2

Turkey

9,890

15,321

1,115

2.8

EU12

EU candidate countries

458


SELECTED INDICATORS

Population

Total, thousands 2010

Working age, percent 2010

Old age, percent 2010

Total, thousands 2050

Working age, percent 2050

Old age, percent 2050

CO2 emissions, metric tons per capita 2008

8,214

67.6

18.1

7,521

56.4

30.1

8.1

10,423

66.2

17.8

9,883

58.1

27.7

9.8

5,516

65.5

16.6

5,575

60.3

24.6

8.4

5,255

66.6

17.2

4,820

58.2

27.3

10.6

64,768

64.9

16.5

69,768

58.9

25.5

5.9

81,644

66.0

20.6

71,542

56.3

30.1

9.6

10,750

66.4

19.4

10,036

54.8

32.1

8.7

4,623

67.7

11.3

6,334

59.9

23.3

9.9

60,749

66.1

20.1

61,416

55.6

31.0

7.4

498

66.8

14.8

721

62.8

20.6

21.5

16,783

67.7

15.2

17,334

59.3

26.0

10.6

10,736

66.0

17.8

9,933

56.2

30.6

5.3

46,506

68.1

16.9

52,491

55.2

31.2

7.2

9,074

65.2

19.3

9,085

59.5

25.7

5.3

62,348

66.3

16.3

71,154

60.8

23.6

8.5

309

67.1

12.4

351

60.0

24.2

7.0

35

69.2

14.5

36

57.5

28.5

â&#x20AC;&#x201D;

4,676

66.2

15.6

4,966

59.9

25.0

10.5

7,623

68.0

16.6

7,296

57.4

29.0

5.3

7,149

68.3

17.9

4,651

53.9

33.8

6.6

1,103

73.3

10.2

1,392

61.5

25.8

7.9

10,202

70.7

15.9

8,540

54.7

33.1

11.2

1,291

67.4

17.6

862

53.7

32.2

13.6

9,992

68.3

16.7

8,490

56.7

29.9

5.4

2,218

69.6

17.0

1,544

55.9

31.2

3.3

3,545

69.7

16.3

2,788

55.7

32.0

4.5

407

69.0

15.1

396

57.2

29.7

6.2

38,464

71.7

13.5

32,085

55.4

31.7

8.3

21,959

70.3

14.8

18,060

56.1

31.3

4.4

5,470

71.7

12.6

4,944

56.7

30.0

6.9

2,003

69.9

16.6

1,597

53.6

34.0

8.5

2,987

67.3

10.3

2,824

62.8

24.0

1.3

4,622

70.9

14.9

3,892

54.4

33.8

8.3

4,487

67.8

16.9

3,864

57.0

29.6

5.3

1,815

65.9

6.6

2,223

66.3

17.0

â&#x20AC;&#x201D;

2,072

69.7

11.5

1,991

59.8

26.2

5.8

667

70.7

13.5

578

54.1

32.4

3.1

7,345

68.1

16.6

5,869

58.0

29.0

6.8

77,804

66.9

6.2

100,955

63.9

19.3

4.0

459


GOLDEN GROWTH

GNI, per capita, US$ 2010

Per capita, PPP, international $ 2010

GDP PPP, international $, billions 2010

Armenia

3,200

5,463

17

8.1

Azerbaijan

5,330

9,943

90

13.6

Belarus

5,950

13,928

132

7.8

Georgia

2,690

5,073

23

5.9

Moldova

1,810

3,110

11

5.1

Ukraine

3,000

6,721

308

5.4

43,590a

39,407a

865a

1.7b

Canada

43,270

38,989

1,330

1.2

New Zealand

28,770a

29,531

129

1.2b

United States

47,390

47,199

14,587

0.9

China

4,270

7,599

10,170

9.6

Indonesia

2,500

4,325

1,037

4.0

Japan

41,850

33,753

4,302

0.9

Korea, Rep.

19,890

29,004

1,418

4.1

Malaysia

7,760

14,731

418

3.0

Real, per capita, growth, percent 2000-10

Eastern partnership countries

North America and Oceania Australia

East Asia

Philippines

2,060

3,969

370

2.8

Singapore

40,070

57,936

294

3.7

Taiwan, China

19,280

35,800

828

3.6

Thailand

4,150

8,554

591

3.4

Vietnam

1,160

3,205

279

6.0

Argentina

8,620

16,012

647

3.1

Brazil

9,390

11,210

2,185

2.5

Chile

10,120

15,732

269

2.7 2.5

Latin America

Colombia

5,510

9,462

438

Mexico

8,890

14,498

1,644

0.9

Peru

4,700

9,538

277

4.2

Uruguay

10,590

14,384

48

2.6

Venezuela, RB

11,590

12,233

353

1.7

Algeria

4,450

8,384

297

2.0

Egypt, Arab Rep.

2,420

6,180

501

3.0

Morocco

2,850

4,712

151

3.5

South Africa

6,090

10,570

528

2.1

Tunisia

4,160

9,550

101

3.5

Africa

Other India

1,330

3,582

4,195

5.8

Russian Federation

9,900

19,840

2,812

5.7

a. 2009. b. 2000-09. â&#x20AC;&#x201D; = not available.

460


SELECTED INDICATORS

Population

Total, thousands 2010

Working age, percent 2010

Old age, percent 2010

Total, thousands 2050

Working age, percent 2050

Old age, percent 2050

CO2 emissions, metric tons per capita 2008

2,967

71.8

10.3

2,943

61.2

25.2

1.8

8,304

70.0

6.6

9,955

65.1

18.1

5.4

9,613

71.6

14.2

7,739

57.8

29.6

6.5

4,601

68.0

16.2

3,785

58.0

28.8

1.2

4,317

73.7

10.6

3,635

58.6

28.3

1.3

45,416

70.7

15.5

33,574

57.9

29.3

7.0

21,516

67.8

13.7

29,013

61.7

22.5

18.6

33,760

68.6

15.5

41,136

58.9

26.3

16.3

4,252

66.5

13.0

5,199

60.8

23.0

7.8

310,233

66.9

13.0

439,010

60.6

20.2

17.9

1,330,141

73.4

8.6

1,303,723

59.5

26.8

5.3

242,968

66.2

6.1

313,021

64.4

18.2

1.7

126,804

64.1

22.6

93,674

52.1

37.0

9.5

48,636

72.7

11.1

43,369

53.9

35.9

10.5

28,275

65.3

4.8

42,929

63.3

16.0

7.6

99,900

60.9

4.2

171,964

64.8

11.7

0.9

5,140

78.0

7.2

8,610

64.3

23.9

6.7

23,025

73.0

10.8

20,161

55.0

34.6

11.2

66,336

70.8

9.0

69,611

59.3

26.0

4.2

89,571

68.8

5.5

111,174

63.7

20.7

1.5 4.8

41,343

63.6

10.9

53,511

62.9

18.9

201,103

66.9

6.6

260,692

62.8

19.3

2.1

16,746

67.9

9.3

19,387

62.0

22.6

4.4 1.5

44,205

66.8

6.0

56,228

64.4

19.1

112,469

64.9

6.4

147,908

62.1

19.0

4.3

28,948

64.7

6.2

36,944

65.1

17.1

1.4

3,301

63.8

13.6

3,495

62.8

21.6

2.5

27,223

64.7

5.3

40,256

64.6

15.3

6.1

34,586

70.1

5.1

44,163

62.8

21.8

3.2

80,472

62.8

4.4

137,873

64.3

13.1

2.7

31,627

65.7

6.0

42,026

62.3

18.6

1.5

49,109

65.9

5.5

49,401

66.8

11.4

8.9

10,525

69.2

7.4

12,180

59.3

24.3

2.4

1,173,108

64.6

5.3

1,656,554

65.5

14.7

1.5

139,390

71.7

13.3

109,187

59.0

26.4

12.0

461


GOLDEN GROWTH

Table A2. Trade Consumption 2009–10a

Goods Intermediate 2009–10a

Austria

7.1

Belgium Denmark

Exports, percentage of GDP

Services

Capital 2009–10a

Traditional 2010

Modern 2010

20.0

6.9

8.8

22.4

44.8

7.2

8.1

9.9

9.8

11.8

5.1

9.3d

5.5d

Finland

2.0

15.7

6.7

3.0

8.6

France

5.1

8.8

3.8

3.5

2.1

Germany

6.0

16.9

7.6

3.2

3.9

EU15 5.6

Greece

2.7

2.8

0.4

11.1

1.2

Ireland

20.4

27.3

5.0

4.3

43.2

Italy

6.2

9.7

3.8

2.6

2.1

Luxembourg

3.6

17.6

2.4

17.0

105.3

Netherlands

11.9

18.7

7.9

5.3

6.5

Portugal

6.7

9.9

1.7

7.5

2.5

Spain

4.9

7.6

1.7

5.6

3.1

Sweden

5.9

15.7

5.6

4.7

9.5

United Kingdom

4.0

8.1

2.3

3.1

7.4

15.0

19.4

1.4

13.9

5.7

Norway

2.7

24.8

1.5

5.1

4.5

Switzerland

13.6

17.5

5.3

3.9

11.7

Bulgaria

10.3

22.7

3.1

11.0

3.5

Cyprus

2.9

2.1

0.5

18.0

16.7

European Free Trade Association Iceland Liechtenstein

EU12

Czech Republic

9.8

34.3

13.1

6.7

4.5

Estonia

11.9

29.0

7.9

15.5

7.1

Hungary

14.7

31.6

17.4

8.3

6.4

Latvia

9.4

20.9

2.9

10.6

4.6

Lithuania

15.2

21.2

5.2

9.7

1.4

Malta

5.6

18.0

1.8

34.3

12.9

Poland

10.1

13.9

3.9

4.2

2.7

Romania

6.3

15.7

4.4

2.7

2.5

Slovak Republic

17.7

32.8

8.8

4.9

1.8

Slovenia

12.8

25.7

4.6

9.2

3.6

EU candidate countries Albania

4.5

8.2

0.2

16.4

2.2

Bosnia and Herzegovina

6.3

18.6

0.9

6.3

1.4

Croatia

4.6

8.7

3.9

15.4

2.8

Kosovo

7.5

3.3

11.6

7.0

0.6

5.8

4.1

22.0

2.7

Serbia

6.6

15.8

1.5

5.1

4.0

Turkey

5.2

6.6

1.6

4.3

0.3

Macedonia, FYR Montenegro

462


SELECTED INDICATORS

Consumption 2009–10a

Goods Intermediate 2009–10a

Imports, percentage of GDP Capital 2009–10a

Traditional 2010

Services

Modern 2010

8.8

20.6

5.3

6.3

18.8

45.8

7.3

8.8

3.4 8.1

8.2

11.0

4.4

8.9d

4.8d

5.2

15.5

3.7

4.4

6.7

5.7

11.6

3.3

3.1

2.0

5.9

16.6

4.5

4.5

3.4

6.1

9.6

3.2

4.7

1.8

8.2

11.6

4.6

4.8

47.6

4.8

13.8

2.4

2.6

2.7

8.2

14.6

4.4

12.6

55.3

9.6

19.2

6.3

5.3

5.6

8.2

17.0

3.4

3.9

2.3

5.6

12.0

2.3

3.0

3.2

6.9

16.1

4.5

4.9

5.4

6.6

10.7

3.2

3.7

3.6

7.3

15.3

3.8

9.5

7.8

4.3

8.1

3.7

6.3

3.9

10.5

14.8

4.7

3.8

3.8

9.6

31.1

5.8

5.7

3.7

11.7

10.3

4.4

10.8

2.7

10.4

38.7

9.7

4.7

4.7

13.4

27.9

7.4

8.7

5.3

8.9

37.8

8.2

5.7

6.4

12.6

19.3

4.9

5.8

3.4

13.1

39.0

6.4

6.2

1.3

15.6

19.5

7.4

10.2

20.6

6.5

18.6

5.5

3.4

2.8

6.5

22.2

5.3

3.2

2.5

13.1

47.9

9.2

5.1

2.7

11.2

29.2

6.0

4.8

4.2

11.4

18.2

3.8

14.7

2.3

14.4

29.4

5.1

2.6

0.8

8.3

17.2

4.4

2.5

3.1

7.0

4.0

11.1

22.1

6.2

4.8

4.0

5.4

4.2

6.4

21.8

4.2

5.7

3.3

2.3

14.2

3.9

1.8

0.6

463


GOLDEN GROWTH

Consumption 2009–10a

Goods Intermediate 2009–10a

Exports, percentage of GDP Capital 2009–10a

Traditional 2010

Services

Modern 2010

Eastern partnership countries Armenia

2.0

8.4

0.2

6.3

1.7

Azerbaijan

0.9

35.5

0.4

2.7

0.9

Belarus

8.4

17.8

5.8

6.6

1.6

Georgia

2.9

8.0

0.7

11.8

1.2

Moldova

15.8

9.4

1.3

7.2

4.0

Ukraine

5.7

26.2

3.4

8.8

3.3

1.6

13.5

0.5

3.2c

1.0c

Canada

2.4

15.6

2.0

1.9

2.4

New Zealand

11.5

8.2

1.2

4.9

1.2

United States

1.1

4.4

1.5

1.4

2.1

North America and Oceania Australia

East Asia China

7.4

9.6

7.8

1.6

1.3

Indonesia

3.3

17.3

1.3

1.4

0.8

Japan

0.6

7.1

3.3

1.2

1.4

Korea, Rep.

1.9

20.0

14.3

6.0

2.1

Malaysia

10.4

56.4

11.3

11.3b

3.6b

Philippines

3.1

17.2

6.6

2.3

4.7

Singapore

11.5

84.9

18.7

21.6

28.7

Taiwan, China

Thailand

13.7

30.1

11.9

8.2

2.4

Vietnam

30.6

23.8

4.9

Argentina

3.1

12.1

1.2

2.0

1.5

Brazil

1.4

6.7

0.8

0.5

0.9

Chile

6.3

25.1

0.4

4.0

1.2

Colombia

2.0

10.4

0.2

1.2

0.3

Mexico

5.6

12.8

6.6

1.3

0.2

Peru

2.7

18.6

0.1

2.0

0.4

Uruguay

8.1

8.5

0.2

4.8

1.3

Venezuela, RB

0.0

11.6

0.1

0.4

0.1

Algeria

0.2

30.2

0.0

0.9b

1.1b

Egypt, Arab Rep.

3.3

7.2

0.1

9.7

1.6b

Latin America

Africa b

Morocco

6.6

9.9

0.4

8.6

3.1

South Africa

2.0

14.8

1.7

3.0

0.8

Tunisia

13.1

16.4

1.9

10.5

1.8

Other India

3.9

6.1

1.1

1.8

6.2

Russian Federation

0.5

18.3

0.5

1.8

1.2

a. Data for the most recent available year. b. 2009. c. 2008. d. 2004. — = not available.

464


SELECTED INDICATORS

Consumption 2009–10a

Goods Intermediate 2009–10a

9.6 2.1

Imports, percentage of GDP

Services

Capital 2009–10a

Traditional 2010

Modern 2010

18.8

5.5

9.2

1.3

6.2

2.7

3.5

3.3

6.9

42.7

7.7

4.0

1.2

13.0

15.7

5.2

6.6

1.9

19.2

23.2

7.6

9.9

2.6

8.4

26.5

4.7

5.7

2.9

3.4

6.0

3.1

3.3c

1.2c

5.1

12.1

4.5

3.4

2.4

5.4

8.9

3.6

4.2

2.0

3.0

6.1

2.2

1.1

1.4

0.7

17.1

4.0

2.1

1.2

1.2

11.3

3.8

2.2

1.4

2.5

7.9

1.3

1.5

1.3

2.8

28.1

5.2

4.9

4.3

5.1

47.8

10.4

9.2b

5.0b

3.4

22.2

2.6

4.5

1.4

11.5

77.0

17.6

20.7

22.5

4.0

42.9

7.8

8.9

5.4

5.9

43.6

14.4

1.8

7.8

3.0

2.4

1.3

0.8

5.1

1.5

1.4

1.5

4.0

11.4

5.0

4.2

1.4

2.1

6.5

3.5

1.7

1.1

3.2

16.7

4.8

1.0

1.1

2.7

10.5

4.2

2.5

1.3

4.0

11.2

3.8

2.6

0.8

3.2

5.6

2.7

2.3

1.2

3.6

14.2

6.3

4.6b

3.4b

3.5

14.7

3.2

b

4.5

2.2b

3.6

20.9

5.1

3.7

1.8

3.1

10.6

4.2

3.6

1.5

5.3

26.3

7.0

5.8

1.4

0.9

16.0

2.6

3.8

3.7

4.4

5.3

3.5

3.0

1.8

465


GOLDEN GROWTH

Table A3. Finance Private sector credit by domestic banks, percentage of GDP 2010

Cross-border banking flows, percentage of GDP 2010

Loan-to-deposit ratio, percent 2010

Foreign bank assets, percentage of total banking assets 2009

Foreign assets plus liabilities, percentage of GDP 2007

EU15 Austria

122.3

7.3

141.4

20

583.0

Belgium

95.4

16.8

108.5

50

1,016.8

Denmark

218.3

16.2

404.5

20

462.0

Finland

94.3

8.8

158.3

65

479.9

France

114.5

10.0

163.0

6

581.1

Germany

107.0

11.4

114.0

12

412.3

Greece

114.3

10.6

152.5

14

277.1

Ireland

215.0

128.8

222.8

56

2,573.1

Italy

122.5

2.2

170.9

6

281.6

Luxembourg

179.3

366.8

57.1

95

24,380.3

Netherlands

199.3

32.7

163.3

2

972.6

Portugal

190.8

7.6

166.2

15

485.3

Spain

211.2

6.9

147.5

2

360.1

Sweden

135.8

13.6

246.7

0

512.1

United Kingdom

204.0

34.1

115.2

15

932.6

107.4

20.3

175.8

1,160.3

Norway

87.0b

7.9

176.7b

16

462.5

Switzerland

176.0

27.1

125.6

5

1,357.1

European Free Trade Association Iceland Liechtenstein

EU12 Bulgaria

74.2

19.5

131.2

79

240.9

Cyprus

283.5

120.9

119.3

19

838.1

Czech Republic

55.0

8.5

112.1

86

179.5

Estonia

97.2

10.4

176.6

99

298.7

Hungary

68.8

15.2

189.5

64

387.1

Latvia

96.0

12.1

236.7

66

248.7

Lithuania

65.2

5.4

166.3

92

158.7

Malta

131.3

114.6

109.8

1,275.3

Poland

52.7

6.4

137.6

68

128.7

Romania

40.3

12.3

157.7

85

112.7

Slovak Republic

48.1

9.3

124.5

88

157.9

Slovenia

92.9

21.2

182.3

25

240.1

Albania

37.8

4.6

98.5

93

81.1

Bosnia and Herzegovina

56.8

6.5

127.3

93

133.0

Croatia

70.1

31.6

137.1

91

209.7

Kosovo

34.2

85.6

Macedonia, FYR

45.3

4.6

99.0

70

138.0

Montenegro

68.6

19.0

151.9

87

Serbia

50.5

12.2

147.0

75

161.9

Turkey

43.9

9.7

139.1

14

100.8

EU candidate countries

466


SELECTED INDICATORS

Capital flows, net, percentage of GDP

Net debt, percentage of GDP 2007

Current account balance, percentage of GDP 2010

Total 2010

–14.6

3.2

–3.5

10.0

1.2

–0.8

–37.7

5.0

2.4

3.1

3.1

–10.7

FDI 2010

Portfolio 2010

Other 2010

–2.3

1.4

–2.6

–16.8

9.5

6.5

–1.5

–0.3

4.1

–2.6

–1.9

–4.4

3.7

–2.1

0.1

–3.3

8.3

–4.8

14.0

5.3

–4.1

–1.7

–5.0

2.7

–71.9

–10.4

9.5

0.3

–9.1

18.2

193.9

–0.7

9.0

5.3

61.5

–57.8

–36.9

–3.5

5.8

–0.7

2.5

4.1

3,008.4

7.7

–15.9

7.1

–6.7

–3.7

–3.6

0.6

–68.6

–9.9

9.7

4.4

–5.6

10.8

–66.7

–4.5

4.4

0.1

3.3

1.0

–33.7

6.5

–7.4

–2.0

1.3

–6.8

–36.0

–2.5

2.4

–0.7

3.6

–0.5

–241.9

–8.0

27.5

9.0

2.4

16.1

22.5

12.9

–9.7

0.3

–4.7

–5.3

109.6

14.2

10.7

–4.3

–3.3

18.3 –2.8

1.2

–0.8

–1.1

3.4

–1.7

34.6

–7.0

6.8

3.5

–5.0

8.3

14.2

–2.4

4.9

2.6

4.2

–1.9

–32.7

3.6

–13.2

6.2

–2.0

–17.4

–40.9

1.6

0.8

–0.4

0.5

0.7

–46.1

3.6

6.2

1.4

–0.8

5.6

–27.3

1.8

–2.6

1.4

5.1

–9.2

76.2

–0.6

–0.9

7.0

–18.5

10.6

–15.7

–3.3

8.7

1.1

5.8

1.8

–11.2

–4.2

7.5

2.0

0.5

4.9

–3.5

–3.4

2.7

1.8

0.8

0.2

–15.0

–1.2

1.1

1.4

5.1

–5.4

14.6

–10.1

11.0

6.8

0.0

4.2

0.7

–6.0

6.0

1.2

0.0

4.9

–29.5

–1.9

–3.7

2.7

2.5

–8.9

–17.3

–3.3

–2.8

3.2

3.2

–0.9

1.0

–25.6

21.5

17.9

0.3

3.3

–14.5

–7.1

3.6

2.9

0.2

0.4

–17.0

–6.5

7.7

1.0

2.2

4.6

467


GOLDEN GROWTH

Private sector credit by domestic banks, percentage of GDP 2010

Cross-border banking flows, percentage of GDP 2010

Loan-to-deposit ratio, percent 2010

Foreign bank assets, percentage of total banking assets 2009

Foreign assets plus liabilities, percentage of GDP 2007

Eastern partnership countries Armenia

25.7

1.5

179.1

79

84.0

Azerbaijan

18.1

4.1

188.7

3

88.7

Belarus

42.7

1.9

227.9

18

54.9

Georgia

32.4

2.1

148.1

64

122.2

Moldova

33.3

1.9

109.4

49

152.2

Ukraine

61.7

4.5

198.0

56

140.8

North America and Oceania Australia

125.4

4.9

142.3

2

258.1

Canada

128.3a

4.6

143.9a

5

219.7

New Zealand

146.7

4.5

169.1

79

233.2

United States

56.9

9.0

120.6

18

278.7

China

131.1

1.1

85.8

1

112.7

Indonesia

26.0

3.6

97.1

32

86.8

Japan

102.0

2.6

104.1

0

193.9

Korea, Rep.

100.3

2.5

147.0

19

135.3

Malaysia

114.8

4.7

107.7

18

222.1

Philippines

24.9

5.0

91.3

1

132.2

Singapore

102.1

17.6

103.7

2

1,038.9

East Asia

Taiwan, China

2.9

336.8

Thailand

97.0

3.3

119.4

6

141.8

Vietnam

125.0

6.7

125.1

2

129.8

Argentina

14.2

2.5

116.9

28

147.6

Brazil

52.3

3.2

151.7

21

102.7

Chile

72.7

10.5

140.8

34

199.8

Colombia

35.2

2.2

212.3

9

81.7

Mexico

18.7

5.6

152.3

75

83.7

Peru

24.6

5.5

87.5

50

123.9

Uruguay

22.3

9.1

68.4

55

174.5

Venezuela, RB

18.7

1.7

88.1

17

115.4

Latin America

Africa Algeria

15.3

0.7

85.0

14

104.1

Egypt, Arab Rep.

33.1

3.8

98.8

23

122.5

Morocco

82.3

4.9

119.5

34

134.3

South Africa

72.6

2.9

149.6

22

174.6

Tunisia

65.4

4.3

130.2

25

169.9

India

49.0

4.1

105.3

5

85.4

Russian Federation

42.9

4.0

121.8

12

179.3

Other

a. 2008. b. 2006. — = not available.

468


SELECTED INDICATORS

Net debt, percentage of GDP 2007

Current account balance, percentage of GDP 2010

4.2 8.2

Capital flows, net, percentage of GDP Total 2010

FDI 2010

Portfolio 2010

Other 2010

–13.7

11.0

8.1

0.0

3.0

27.7

–24.8

0.1

–0.1

–24.8

–8.2

–15.5

12.9

2.3

2.2

8.4

–15.7

–9.8

10.0

4.3

2.4

3.4

–19.4

–10.9

11.9

2.9

0.1

8.9

4.6

–1.9

6.7

4.2

3.1

–0.6

–52.2

–2.6

2.6

0.4

5.4

–3.2

–19.4

–3.1

3.4

–1.0

6.4

–2.0

–59.7

–2.2

2.4

0.1

2.3

0.1

–39.4

–3.2

1.6

–1.0

4.5

–1.9

52.3

5.2

2.8

2.2

0.2

0.4

–17.0

0.9

3.7

1.4

2.2

0.2

55.8

3.6

–2.6

–1.1

–2.8

1.3

3.4

2.8

0.2

–1.9

3.8

–1.7

53.1

11.8

–2.9

–2.0

5.9

–6.8

–5.6

4.5

4.3

0.6

2.1

1.5

150.4

22.2

–3.0

8.5

–9.8

–1.6

109.0

9.4

–0.3

–2.0

–4.8

6.5

32.3

4.6

4.9

0.4

2.7

1.8

8.8

–3.8

13.0

5.9

2.3

4.8

19.2

0.9

–0.1

1.3

2.4

–3.7

1.2

–2.3

4.7

1.8

2.8

0.2

7.5

1.9

–2.9

3.1

–3.9

–2.1

0.1

–3.1

4.2

0.9

1.0

2.3

–0.6

–0.5

3.5

0.5

3.6

–0.6

0.2

–1.5

8.4

4.7

1.9

1.8

10.1

0.5

–1.2

3.2

–3.1

–1.4

46.9

4.9

–5.2

–0.1

1.1

–6.2

86.3

9.4

1.5

1.5

0.0

0.0

36.2

–2.0

6.0

2.6

3.4

–0.1

24.0

–4.2

4.2

0.2

0.0

3.9

4.5

–2.8

3.1

0.3

3.0

–0.3

–28.1

–4.8

4.0

3.1

–0.1

0.9

7.5

–3.2

4.9

1.5

2.2

1.2

20.9

4.9

–1.5

–0.2

0.0

–1.3

469


GOLDEN GROWTH

Table A4. Enterprise

1995

Level

Labor productivity, constant 2005 US$, thousands Industry Level CAGR percent 2009 1995 2009 Total

CAGR percent

EU15 Austria

60.8

73.7

1.4

53.1

81.0

3.1

Belgium

73.2

80.2

0.7

63.3

76.3

1.3

Denmark

71.3

78.9

0.7

71.3

89.1

1.6

Finland

59.1

71.8

1.4

56.8

94.2

3.7

France

72.6

77.2

0.4

56.1

63.6

0.9

Germany

62.1

67.0

0.5

53.0

58.9

0.8

Greece

46.1

56.4

1.4

35.2

40.8

1.1

Ireland

73.3

98.1

2.1

77.7

159.7

5.3

Italy

73.2

68.2

–0.5

60.1

55.6

–0.6

Luxembourg

142.8

188.2

2.0

96.7

185.6

4.8

Netherlands

67.4

76.5

0.9

77.2

96.6

1.6

Portugal

31.9

36.7

1.0

24.2

26.6

0.7

Spain

60.8

56.9

–0.5

56.0

59.3

0.4

Sweden

60.6

74.1

1.4

54.8

91.9

3.8

United Kingdom

59.2

71.8

1.4

62.4

74.7

1.3

61.5

84.7a

2.5

63.0

96.3a

3.3

Norway

105.6

111.9

0.4

209.5

210.2

0.0

Switzerland

81.6

96.9

1.2

80.6

116.3

2.6

European Free Trade Association Iceland Liechtenstein

EU12 Bulgaria

6.4k

8.8

2.5

4.9k

7.3

3.1

Cyprus

32.0

34.0a

0.5

27.3

27.2a

0.0

Czech Republic

18.4

27.1a

3.0

15.4

27.0a

4.4

Estonia

10.6

21.7a

5.7

8.2

17.3a

5.9

Hungary

17.9

25.7a

2.8

14.5

24.8a

4.2

Latvia

8.6

15.3

4.2

6.1

11.7

4.7

Lithuania

10.1

18.1

4.3

9.4

19.1

5.2

Malta

32.8j

33.1

0.1

43.2j

41.7

–0.3

Poland

15.0

22.7

3.0

11.4

21.8

4.7

Romania

9.7

15.6

3.4

5.8

11.1

4.8

Slovak Republic

18.1

26.7

2.8

13.5

33.1

6.6

Slovenia

25.7

40.2a

3.5

17.8

36.6a

5.7

Albania

8.3

12.5d

4.2

7.9

10.7d

3.0

Bosnia and Herzegovina

5.0

6.5

3.4

3.4

5.8

7.0

Croatia

17.6k

25.2

2.8

13.8k

22.3

3.8

Kosovo

9.2f

10.3a

1.9

7.1f

9.2a

4.3

Montenegro

10.3h

13.3b

3.8

8.1h

11.6b

5.3

Serbia

e

7.9

a

10.9

8.4

e

7.6

9.2a

5.0

Turkey

21.1

24.8

1.2

17.7

23.3

2.0

EU candidate countries

Macedonia, FYR

470

g

g


SELECTED INDICATORS

Level

Services

Doing Business, index 0–100 Start-up Operations 2011 2011

2009

CAGR percent

Total 2011

64.9

71.0

0.6

77.1

86.9

83.2

75.6

77.2

81.5

0.4

80.9

87.6

83.4

79.4

71.3

76.2

0.5

91.3

97.5

96.9

75.1

60.0

64.2

0.5

82.2

96.9

84.3

74.2

79.2

81.4

0.2

73.7

80.7

81.7

73.7

67.5

70.3

0.3

74.0

82.6

81.1

75.8

50.6

61.4

1.4

55.8

71.1

69.1

50.4

71.3

80.4

0.9

89.2

92.0

90.2

90.6

80.6

73.7

–0.6

64.4

82.6

75.1

48.2

160.2

188.7

1.2

64.3

76.8

74.7

63.4

64.3

71.9

0.8

76.6

91.6

81.2

71.0

36.4

41.3

0.9

71.2

91.7

76.3

64.4

63.1

56.0

–0.9

66.2

83.7

72.6

63.4

62.7

69.4

0.7

82.9

94.9

88.3

72.5

58.0

71.1

1.5

90.2

90.7

91.9

91.9

60.9

81.2a

2.2

79.2

95.7

77.7

79.6

72.1

86.1

1.3

82.6

98.9

83.3

76.3

82.0

91.2

0.8

76.7

86.5

86.4

66.6

1995

Institutions 2011

7.5k

9.8

2.1

68.9

79.8

74.4

71.4

33.8

36.1a

0.5

68.9

83.5

78.3

58.0

20.8

27.1a

2.0

70.3

81.9

78.9

69.0

12.0

24.3a

5.6

74.9

86.2

82.8

71.1

19.7

26.2a

2.2

68.6

84.5

74.7

65.6

9.8

16.5

3.8

75.2

86.6

77.3

83.6

10.4

17.6

3.8

73.6

88.6

77.7

74.3

26.9j

30.0

0.9

17.5

23.2

2.0

68.2

77.1

75.3

71.1

14.0

18.8

2.1

61.6

78.2

64.0

77.2

21.5

22.6

0.4

67.3

85.7

71.5

69.4

33.1

42.5a

1.9

65.7

88.2

69.6

59.1 74.3

8.5

13.4d

4.7

58.5

79.2

59.2

6.1g

6.9

1.6

55.4

72.3

66.3

59.0

19.8k

26.6

2.3

57.4

77.7

64.6

60.6

56.1

78.0

66.9

45.6

10.8f

11.0a

0.3

76.7

87.0

81.1

75.6

11.3h

14.0b

3.1

70.8

81.4

78.9

65.1

8.1e

11.8a

9.9

61.3

76.8

68.4

67.5

23.4

25.5

0.6

61.2

78.1

69.9

63.6

471


GOLDEN GROWTH

1995

Level

Labor productivity, constant 2005 US$, thousands Industry Level CAGR percent 2009 1995 2009 Total

CAGR percent

Eastern partnership countries Armenia

1.5

6.3

10.6

2.0

10.1

12.2

Azerbaijan

2.8

8.7a

9.2

5.2

32.7a

15.2

Belarus

3.1

7.8

6.9

2.7

10.2

9.9

Georgia

2.9i

6.6b

9.5

4.5i

9.4b

8.5

Moldova

1.6k

2.7a

4.4

1.8k

1.4a

–2.4

Ukraine

5.5

4.7a

–1.2

2.6

6.1a

6.8

Australia

52.9

64.1a

1.5

67.6

78.7a

1.2

Canada

58.5

66.2

c

1.1

88.3

94.6c

0.6

New Zealand

45.9

50.7c

0.9

47.8

53.1c

1.0

United States

68.8

84.6a

1.6

66.8

90.7a

2.4

China

2.3

6.1a

7.8

2.6

7.3a

8.3

Indonesia

4.2

4.7

0.8

6.9

7.9

1.0

Japan

65.7

76.3a

1.2

59.6

80.2a

2.3

Korea, Rep.

26.3

38.1a

2.9

24.5

55.9a

6.6

Malaysia

11.8

15.3

1.9

16.8

23.6

2.4

North America and Oceania

East Asia

Philippines

4.1

4.7

0.9

6.3

7.8

1.5

Singapore

41.6

58.1

2.4

44.5

80.2

4.3

Taiwan, China

34.0g

39.7a

2.2

21.7g

29.0a

4.2

Thailand

7.7

7.8

0.1

8.4

11.3

2.1

Vietnam

2.0k

2.0b

0.1

2.4k

2.5b

0.3

Argentina

10.6

11.1

0.3

15.0

17.9

1.3

Brazil

10.6

10.6

0.0

13.6

11.3

–1.3

Chile

17.1

20.0

1.1

25.6

31.0

1.4

Colombia

8.5

11.0

1.9

11.6

15.4

2.0

Mexico

21.9

21.5

–0.1

27.0

26.3

–0.2 4.1

Latin America

Peru

5.4

7.7a

2.7

7.4

12.6a

Uruguay

10.9

11.5b

0.4

10.6

14.6b

2.7

Venezuela, RB

18.5

13.4d

–3.2

43.8

34.6d

–2.3

Africa 10.9g

10.1e

–2.5

23.7g

20.5e

–4.7

Egypt, Arab Rep.

4.2

5.7a

2.4

5.6

7.3a

2.1

Morocco

4.0

8.5a

5.9

3.7

7.5a

5.6

South Africa

16.9h

18.5

1.0

20.0h

21.5

0.8

Tunisia

10.8d

12.1

2.8

8.8d

9.8

2.5

Algeria

Other India

2.8h

3.5d

4.2

2.5h

2.8d

2.0

Russian Federation

7.6

11.8

3.3

7.3

13.2

4.3

a. 2008. b. 2007. c. 2006.

472

d. 2005. e. 2004. f. 2002.

g. 2001. h. 2000. i. 1998.

j. 1997. k. 1996. — = not available.


SELECTED INDICATORS

Level

Services

Doing Business, index 0–100 Start-up Operations 2011 2011

2009

CAGR percent

Total 2011

1.2

4.7

10.2

66.9

90.2

70.4

58.9

1.6

2.5a

3.5

55.4

83.9

50.9

72.1

3.3

6.3

4.7

57.7

82.8

60.4

67.6

2.5i

5.8b

9.7

82.2

89.8

87.2

79.5

1.5k

3.2a

6.4

57.0

81.9

57.6

71.5

11.3

4.2a

–7.3

44.6

63.1

49.4

72.1

48.2

59.9a

1.7

85.8

94.1

88.3

80.6

49.7

58.0c

1.4

89.4

97.4

90.1

79.2

45.1

49.9c

0.9

92.4

100.0

88.7

96.5

69.4

83.0a

1.4

90.7

93.2

92.3

90.4

2.1

5.2a

7.3

59.7

74.0

69.7

67.0

2.9

3.3

0.8

51.8

67.4

72.3

44.4

69.1

74.7a

0.6

82.8

89.7

86.9

80.6

27.4

31.5a

1.1

82.6

89.8

87.4

79.1

8.3

11.5

2.3

80.7

84.8

82.3

92.9

3.3

3.8

1.1

49.4

58.1

71.9

48.3

40.3

51.8

1.8

100.0

98.9

100.0

100.0

42.2g

46.7a

1.4

70.1

94.3

74.2

58.0

7.2

6.0

–1.3

76.4

81.1

86.7

73.4

1.7k

1.6b

–0.5

60.0

73.7

72.2

65.7

1995

Institutions 2011

9.0

9.0

0.0

55.9

69.9

67.0

61.7

9.5

10.4

0.6

38.4

60.1

48.7

51.4

13.3

16.1

1.4

68.4

77.2

79.4

68.9

7.0

9.5

2.2

71.6

88.3

75.2

62.2

19.8

19.6

–0.1

69.4

82.9

75.1

68.9

4.7

6.3a

2.2

67.3

82.1

73.4

71.4

11.1

10.5b

–0.4

58.7

79.7

65.1

57.2

9.0

6.9d

–2.6

10.1

54.5

19.9

37.3

5.2g

5.0e

–1.4

48.0

69.6

60.0

47.8

3.5

4.8a

2.6

56.7

74.5

69.7

51.8

4.2

9.0a

6.0

58.5

77.3

68.7

55.6

15.6h

17.4

1.2

65.3

79.8

62.8

87.8

12.1d

13.6

2.9

66.9

82.3

77.4

59.4

3.0h

4.0d

5.7

50.0

67.7

63.7

50.1

7.7

11.2

2.7

49.1

81.3

48.9

61.7

473


GOLDEN GROWTH

Table A5. Innovation Enrollment in doctorate level, per 1,000 population ages 25–34

Tertiary education attainment, percentage of population ages 30–34 IIASA/VID

R&D expenditure, percentage of GDP Public

Business

2005–10a

2010

IUS

2005–10a

2005–10a

Austria

18.2

20.5

23.5

0.8

1.9

Belgium

9.7

42.0

42.0

0.6

1.3

Denmark

10.7

32.9

48.1

1.0

2.0

Finland

31.6

47.2

45.9

1.1

2.7

France

8.8

39.4

43.3

0.8

1.4

29.1

29.4

0.9

1.9

Greece

13.5

28.3

26.5

0.4

0.2

Ireland

9.1

44.1

49.0

0.6

1.2

Italy

4.9

16.8

19.0

0.6

0.7

Luxembourg

25.5

46.6

0.4

1.2

Netherlands

3.8

29.1

40.5

1.0

0.9

Portugal

9.5

30.0

21.1

0.7

0.8

Spain

10.3

15.4

39.4

0.7

0.7

Sweden

18.4

29.3

43.9

1.1

2.6

United Kingdom

10.3

35.1

41.5

0.7

1.1

Iceland

6.4

41.8

1.1

1.4

Liechtenstein

7.1

Norway

12.2

38.1

47.0

0.9

0.9

Switzerland

19.4

43.5

0.7

2.2

Bulgaria

3.7

27.9

27.9

0.4

0.2

Cyprus

2.3

24.7

44.7

0.3

0.1

Czech Republic

15.3

16.1

17.5

0.6

0.9

Estonia

13.2

22.0

35.9

0.8

0.6

Hungary

4.5

18.7

23.9

0.5

0.7

Latvia

6.4

23.1

30.1

0.3

0.2

Lithuania

5.7

21.4

40.6

0.6

0.2

Malta

1.2

21.1

21.1

0.2

0.3

Poland

5.1

23.4

32.8

0.5

0.2

Romania

7.7

14.2

16.8

0.3

0.2

Slovak Republic

11.3

17.1

17.6

0.3

0.2

Slovenia

6.6

24.9

31.6

0.7

1.2

EU15

Germany

European Free Trade Association

EU12

EU candidate countries Albania

0.2

Bosnia and Herzegovina

0.0

Croatia

4.9

15.0

20.5

0.5

0.3

Kosovo

0.7

14.7

14.3

0.2

0.1

Macedonia, FYR Montenegro

474

1.1

0.1

Serbia

2.8

19.2

0.8

0.1

Turkey

2.7

12.5

14.7

0.5

0.3


SELECTED INDICATORS

Patent applications, per billions of GDP PPP$

PPS€

Medium- and hightech product exports, percentage of goods exports

2005–09a

IUS

2009–10a

2008–10a

2008–10a

2005–10a

7.9

5.0

52.4

46.3

0.17

1.1

2.1

3.7

48.1

63.4

0.46

1.2

7.9

8.0

37.8

0.74

1.6

10.3

10.0

45.6

46.6

0.98

1.6

7.5

3.9

58.6

19.8

0.40

1.1

20.0

7.7

63.2

61.3

0.43

0.9

2.2

0.4

28.6

9.2

0.02

1.4

5.4

2.6

49.3

80.5

1.10

1.1

5.0

2.1

50.4

43.8

0.18

0.7

2.0

1.2

31.6

71.9

0.87

4.2

6.4

40.5

58.7

0.67

1.1

1.5

0.5

36.6

38.7

0.02

0.8

2.6

1.3

49.2

41.1

0.06

1.0

7.8

11.0

51.0

27.1

1.35

1.4

10.3

3.5

50.6

66.5

0.64

0.4

7.4

3.0

12.2

19.1

0.00

1.2

0.2

18.7

3.1

14.2

69.8

0.12

1.2

5.9

9.1

63.6

54.7

2.46

1.2

2.5

0.4

25.7

40.7

0.07

0.8

0.5

0.5

40.0

48.9

0.04

0.9

3.3

1.0

62.1

56.8

0.06

0.9

3.6

2.0

34.5

53.7

0.10

1.0

3.9

1.5

68.0

40.2

0.80

0.9

4.4

0.7

28.4

62.3

0.05

0.9

1.9

0.3

31.8

54.2

0.00

0.9

2.8

1.3

71.3

29.9

0.36

0.4

4.3

0.3

52.4

58.2

0.05

0.9

3.6

0.1

50.7

66.4

0.29

1.1

1.9

0.5

62.3

51.1

0.05

0.6

6.8

2.6

56.9

43.7

0.14

0.9 —

Knowledgeintensive services exports, percentage of services exports

Royalties and license fees from abroad, percentage of GDP

Public tertiary education spending, percentage of GDP

11.6

21.7

0.01

2.2

17.1

34.0

0.09

3.6

0.9

45.1

18.9

0.05

0.8

26.6

0.02

19.7

0.1

13.3

53.3

0.08

0.5c

105.8

18.1

0.08

4.3

26.1

57.1

0.10

2.7

0.7

38.6

26.8

0.00

0.7b

475


GOLDEN GROWTH

Enrollment in doctorate level, per 1,000 population ages 25–34

Tertiary education attainment, percentage of population ages 30–34 IIASA/VID IUS

R&D expenditure, percentage of GDP Public

Business

2005–10a

2005–10a

2005–10a

2010

Armenia

2.8

27.4

0.3

Azerbaijan

1.3

0.2

0.1 0.3

Eastern partnership countries

Belarus

2.9

0.2

Georgia

2.5

0.2

Moldova

2.5

0.5

0.1

Ukraine

5.0

22.6

0.4

0.5

Australia

14.5

33.9

0.9

1.4

Canada

8.1

50.2

0.9

1.1

New Zealand

13.4

31.3

0.7

0.5

United States

11.0

32.9

54.4

0.7

2.0 1.1

North America and Oceania

East Asia China

8.7

9.3

9.0

0.4

Indonesia

1.9

11.7

0.0

Japan

4.5

52.7

56.7

0.7

2.7

Korea, Rep.

6.6

48.3

0.8

2.5

Malaysia

3.2

22.2

0.1

0.5

Philippines

0.5

29.6

0.0

0.1

Singapore

6.9

50.9

0.7

1.9

Thailand

2.1

24.5

0.1

0.1

Vietnam

3.5

7.0

0.2c

0.0c

Argentina

2.0

18.9

0.4

0.1

Brazil

1.7

10.6

11.9

0.5b

0.4b

Chile

1.5

35.1

0.3b

0.3b

Colombia

0.2

21.0

0.1

0.0

Mexico

1.0

18.0

0.2

0.2

16.9

0.1b

0.0b

Uruguay

0.4

9.2

0.5

0.1

Venezuela, RB

1.4

8.3

21.8

6.6

12.0

0.5

0.1

Taiwan, China

Latin America

Peru

Africa Algeria Egypt, Arab Rep. Morocco South Africa Tunisia

13.9

0.4

0.5

17.3

0.9

0.2

10.8

9.0

0.5

0.3

7.1

30.2

70.2

0.5

0.8

Other India Russian Federation

a. Data for the most recent available year. b. 2004. c. 2002. — = not available.

476


SELECTED INDICATORS

Patent applications, per billions of GDP PPP$

PPS€

Medium- and hightech product exports, percentage of goods exports

2005–09a

IUS

2009–10a

2008–10a

2008–10a

2005–10a

7.8

16.8

38.7

0.00

0.3

3.0

2.0

47.4

0.00

0.2

14.1

34.6

80.2

0.02

0.7

22.4

45.9

41.4

0.04

0.3

13.6

17.8

63.5

0.08

1.4

16.6

39.5

53.4

0.10

1.8

33.0

9.4

26.1

0.07

0.7

29.4

36.0

50.2

0.24

1.5

50.4

11.9

11.8

0.13

1.1

32.5

4.3

52.3

45.9

0.72

1.0

34.7

1.1

58.1

34.3

0.01

6.0

18.0

21.6

0.01

0.3 0.5

Knowledgeintensive services exports, percentage of services exports

Royalties and license fees from abroad, percentage of GDP

Public tertiary education spending, percentage of GDP

85.4

8.3

73.8

40.3

0.49

123.6

73.7

58.9

0.31

0.6

13.7

53.2

32.9

0.14

1.6b

10.0

74.4

75.7

0.00

0.3

34.6

62.2

36.5

0.84

1.2

12.3

52.5

18.0

0.05

0.8

10.9

16.6

25.0

48.6

0.04

0.9

11.8

0.4

24.7

62.9

0.02

0.7

16.2

4.6

59.7

0.03

0.3

5.2

12.6

39.4

0.02

0.8

9.2

63.2

17.4

0.00

0.9

2.8

2.7

29.4

0.00

0.4

17.5

9.6

33.7

0.00

0.6

1.8

37.6

0.00

1.6

3.2

0.1

61.0

0.00

4.0

16.1

21.8

0.00

7.4

29.8

42.0

0.00

1.0

31.4

18.9

0.02

0.6

5.2

33.7

34.6

0.06

1.7

10.2

0.5

25.5

79.6

0.01

0.6

14.4

0.5

9.0

59.3

0.04

0.9

477


GOLDEN GROWTH

Table A6. Labor Labor force Total, thousands

Change from 2010, younger, percent

Change from 2010, older, percent

Unemployment, percentage of labor force

Net migration, per 1,000 population

2010

2020

2020

2005–09a

2010

Austria

4,266

–2.9

4.4

4.8

19.1

Belgium

4,739

–1.6

2.9

7.9

18.4

Denmark

2,862

–1.3

0.5

6.0

16.3

Finland

2,664

0.4

–5.6

8.2

13.5

France

28,497

–0.4

0.0

9.1

7.7

Germany

41,967

–4.7

–0.4

7.7

6.7

Greece

5,066

–17.5

9.6

9.5

13.6

Ireland

2,271

–6.3

30.0

11.7

22.3

Italy

24,864

–17.0

8.1

7.8

33.0

Luxembourg

225

12.7

12.7

5.1

84.0

Netherlands

8,899

2.5

1.7

3.4

3.0

Portugal

5,337

–16.9

11.4

9.5

14.1

Spain

22,522

–14.9

25.6

18.0

48.8

Sweden

4,835

1.7

3.8

8.3

28.3

United Kingdom

31,046

4.0

4.2

7.7

16.4

192

3.0

15.4

7.2

32.8

Norway

2,513

4.2

9.6

3.2

35.1

Switzerland

4,197

0.9

2.2

4.1

23.4

3,494

–20.6

2.1

6.8

–6.6

440

9.9

13.5

5.2

40.0

EU15

European Free Trade Association Iceland Liechtenstein

EU12 Bulgaria Cyprus Czech Republic

5,099

–18.8

12.3

6.7

22.8

Estonia

670

–9.4

–0.2

13.7

0.0

Hungary

4,227

–16.1

10.0

10.0

7.5

Latvia

1,153

–11.3

3.9

17.1

–4.5

Lithuania

1,526

–6.7

–5.0

13.7

–10.7

Malta

169

–4.3

8.8

6.9

12.1

Poland

17,146

–10.4

1.3

8.2

1.5

Romania

9,016

–19.7

7.2

6.9

–4.7

Slovak Republic

2,724

–13.6

11.5

12.1

6.8

Slovenia

1,005

–13.6

2.1

5.9

10.7

Albania

1,411

10.4

4.0

12.7

–14.9

Bosnia and Herzegovina

1,910

–9.3

3.2

23.9

–2.7

Croatia

1,941

–9.6

–1.0

9.1

2.3

Kosovo

45.4

900

–6.9

6.5

32.2

1.0 –4.0

EU candidate countries

Macedonia, FYR Montenegro

478

30.3

Serbia

4,294

–6.9

5.1

16.6

0.0

Turkey

25,393

1.7

28.9

14.0

–0.7


SELECTED INDICATORS

Emigration of tertiary educated, percentage of total tertiary educated

Self-employment, percentage of total employment

Shadow economy, percentage of officialbGDP

Minimum wage, international $, PPP

Hiring and firing practices, index 1–7

2000

2004–08a

2007

2006–09a

2010

13.5

9.0

9.5

3.6

5.5

10.0

21.3

1,492

2.9

7.8

5.0

16.9

6.1

7.2

9.0

17.0

4.0

3.5

5.9

14.7

1,443

2.7

5.8

6.8

15.3

2.8

12.2

27.0

26.5

1,096

3.0

33.7

11.7

15.4

1,368

3.7

9.7

18.6

26.8

3.0

8.6

5.2

9.4

1,687

3.4

9.6

9.4

13.0

1,606

3.1

19.0

18.5

23.0

618

2.4

4.2

11.8

22.2

911

2.6

4.5

6.6

17.9

2.5

17.1

10.5

12.2

1,507

4.4

21.0

8.7

15.0

5.3

18.5

6.2

5.7

18.0

2.8

9.6

10.1

8.1

5.8

9.6

8.7

32.7

292

4.1

34.2

14.4

26.5

1,044

3.9

8.5

12.5

17.0

526

3.2

9.9

5.8

29.5

426

4.5

12.8

7.1

23.7

498

4.2

8.5

6.8

27.2

421

4.2

8.4

9.4

29.7

428

3.2

58.3

9.0

26.5

3.5

14.3

18.9

26.0

628

3.3

11.3

31.2

30.2

320

3.6

14.3

10.6

16.8

485

3.2

11.0

11.0

24.7

855

2.3

17.5

32.9

329

4.7

20.3

26.9

32.8

4.5

24.6

16.2

30.4

613

3.2

29.4

22.2

34.9

4.3

19.5

4.1

22.7

376

3.6

5.8

35.3

29.1

609

4.0

479


GOLDEN GROWTH

Labor force Total, thousands

Change from 2010, younger, percent

Change from 2010, older, percent

Unemployment, percentage of labor force

Net migration, per 1,000 population

2010

2020

2020

2005–09a

2010 –24.3

Eastern partnership countries Armenia

1,603

2.1

–5.8

28.6

Azerbaijan

4,226

11.7

9.8

6.1

5.9

Belarus

4,916

–12.9

–3.6

–5.3

Georgia

1,987

–6.1

–2.6

16.5

–33.7

Moldova

1,409

–1.6

–11.5

6.4

–48.2

Ukraine

21,382

–14.6

–3.2

8.8

–0.9

Australia

11,102

4.9

12.2

5.6

50.4

Canada

18,731

4.7

9.8

8.3

32.2

New Zealand

2,263

7.4

9.1

6.1

14.9

United States

157,138

6.5

8.6

9.3

16.0

China

776,111

–5.0

11.4

4.3

–1.4

Indonesia

110,128

2.1

32.3

7.9

–5.4

Japan

59,721

–18.3

3.5

5.0

2.1

Korea, Rep.

23,014

–10.5

15.5

3.6

–0.6

North America and Oceania

East Asia

Malaysia

11,928

12.1

26.0

3.7

3.0

Philippines

38,134

14.5

33.4

7.5

–13.2

Singapore

2,543

9.3

6.6

5.9

142.2

5.9

Thailand

37,372

–4.7

14.2

1.2

7.1

Vietnam

47,204

4.1

26.2

2.4

–5.0

Argentina

18,337

3.8

24.5

8.6

–4.9

Brazil

98,703

3.8

28.1

8.3

–2.6

Chile

7,347

9.1

22.8

9.7

1.8

Colombia

18,630

8.6

28.3

12.0

–2.6

Taiwan, China

Latin America

Mexico

47,019

0.0

38.5

5.2

–15.9

Peru

13,252

9.3

33.5

6.8

–24.9

Uruguay

1,612

3.0

13.4

7.3

–14.9

Venezuela, RB

13,101

14.5

29.1

7.6

1.4

Africa Algeria

14,855

1.1

44.8

11.3

–3.9

Egypt, Arab Rep.

27,634

14.2

27.7

9.4

–4.3

Morocco

11,919

7.2

26.3

10.0

–21.1

South Africa

19,358

7.6

6.9

23.8

14.0

Tunisia

3,722

0.4

28.4

14.2

–1.9

Other India

474,806

14.0

25.3

4.4

–2.6

Russian Federation

73,322

–11.0

–1.8

8.2

8.0

a. Data for the most recent available year. b. 2006. c. 1994. — = not available.

480


SELECTED INDICATORS

Emigration of tertiary educated, percentage of total tertiary educated

Self-employment, percentage of total employment

Shadow economy, percentage of officialbGDP

Minimum wage, international $, PPP

Hiring and firing practices, index 1–7

2000

2004–08a

2007

2006–09a

2010

8.9

50.3

41.1

144

4.8

1.8

62.6

52.0

121

5.3

3.2

43.3

250

2.8

62.2

62.1

21

5.0

4.1

32.4

44.3b

3.5

4.3

19.3

46.8

311

4.8

2.7

9.3

13.5

1,597

3.5

4.7

10.4

15.3

1,325

4.9

21.8

11.9

12.0

1,367

3.7

0.5

7.2

8.4

1,257

5.1

3.8

11.9

173

4.3

2.9

63.1

17.9

148

4.2

1.2

10.8

10.3

944

2.8

7.5

25.2

25.6

797

3.3

10.5

22.3

29.6

4.5

13.6

44.7

38.3

379

3.3

14.5

10.2

12.2

5.8

12.8

19.8

23.9

3.8

2.2

53.3

48.2

295

4.4

27.0

73.9

14.4

85

4.3

2.8

20.1

23.0

896

2.7

2.0

27.2

36.6

286

2.9

6.0

24.8

18.5

400

3.4

10.4

40.9

33.5

390

3.9

15.5

29.5

28.8

170

3.1

5.8

39.6

53.7

334

3.5

9.0

25.1

46.1

258

3.0

3.8

29.8

30.9

481

2.3

9.5

34.9

31.2

308

3.8

4.7

24.8

33.1

14

3.7

18.6

51.1

33.1

371

4.0

7.4

2.7

25.2

390

2.5

12.6

20.9c

35.4

315

3.9

4.3

20.7

121

4.0

1.4

5.8

40.6

223

3.7

481


GOLDEN GROWTH

Table A7. Government Government revenue, percentage of GDP Total

Taxes

Individual income tax

Corporate income tax

Taxes on goods and services

2004–09a

2004–09a

2004–09a

2004–09a

2004–09a

EU15 Austria

48.8

27.6

10.0

1.9

12.2

Belgium

48.2

28.4

12.1

2.5

10.5

Denmark

55.9

47.1

26.7

2.4

14.7

Finland

53.1

30.6

13.2

3.5

12.8

France

48.9

25.1

7.6

1.3

10.6

Germany

44.9

24.0

10.0

0.7

11.1

Greece

37.8

19.5

5.1

2.4

10.7

Ireland

34.3

22.0

7.8

2.5

Italy

46.7

29.1

11.8

2.4

11.5

Luxembourg

41.4

25.8

7.7

5.5

11.3

Netherlands

46.0

24.0

8.6

2.1

11.9

Portugal

38.7

21.7

5.7

2.9

11.2

Spain

34.7

18.7

7.0

2.3

7.2

Sweden

54.0

38.3

16.5

2.8

13.4

United Kingdom

40.3

27.8

10.4

2.8

10.1

41.1

30.8

12.9

1.8

11.7

Norway

57.2

32.2

10.5

8.4

11.8

Switzerland

34.3

22.4

9.1

3.3

5.3

Bulgaria

36.1

22.4

3.0

2.5

15.3

Cyprus

39.8

26.3

3.9

6.5

13.8

Czech Republic

37.4

18.2

3.5

3.5

10.8

European Free Trade Association Iceland Liechtenstein

EU12

Estonia

43.4

22.4

5.7

1.8

14.5

Hungary

46.1

26.2

7.3

2.2

15.5

Latvia

35.4

17.9

5.5

1.5

10.1

Lithuania

34.9

17.5

4.1

1.8

11.1

Malta

39.2

27.6

6.1

6.8

13.6

Poland

37.0

20.4

4.6

2.3

11.8

Romania

32.1

18.4

3.6

2.7

11.0

Slovak Republic

33.6

15.8

2.7

2.6

10.1

Slovenia

43.9

21.7

5.9

2.0

13.1

Albania

26.0

19.6

2.3

1.7

13.9

Bosnia and Herzegovina

43.1

22.3

1.0

1.0

18.8

Croatia

38.2

21.9

3.1

2.8

14.8

Kosovo

29.3

Macedonia, FYR

34.9

20.5

2.2

2.1

13.4

Montenegro

42.4

Serbia

44.1

25.9

4.9

1.2

17.3

Turkey

33.9

19.3

4.0

2.0

11.6

EU candidate countries

482


SELECTED INDICATORS

Government expenditure, percentage of GDP Total

Health

Education

Social protection

Public debt, percentage of GDP

2004–09a

2004–09a

2004–09a

2004–09a

2009

52.3

8.2

5.8

21.8

69.6

54.3

8.0

6.4

19.5

96.3

58.8

8.8

8.0

25.4

41.8

55.6

7.9

6.6

23.6

43.3

56.5

8.4

6.2

23.7

79.0

48.0

6.9

4.4

21.8

74.1

53.2

5.2

3.2

20.4

127.1

48.6

8.8

5.6

16.4

65.2

51.9

7.5

4.8

20.4

116.1

42.3

5.0

5.0

18.3

14.6

51.4

6.8

6.0

18.1

60.8

48.0

7.0

6.6

17.4

83.0

45.8

6.7

5.0

16.1

53.3

55.2

7.4

7.3

23.0

42.8

51.5

8.5

6.9

18.0

68.3

51.0

8.4

8.6

11.3

88.2

2.1

47.1

7.8

6.1

18.3

55.4

33.7

1.9

5.7

13.8

54.8

36.6

3.9

4.2

13.3

15.6

45.8

3.0

7.8

9.9

58.0

44.2

6.6

4.3

13.6

35.4

45.2

5.6

7.0

15.7

7.2

50.5

5.0

5.3

18.3

78.4

42.3

3.7

6.7

13.3

32.8

44.1

6.7

6.8

16.4

29.6

42.9

5.5

5.5

14.7

67.3

44.1

5.1

5.3

16.9

50.9

37.6

3.7

4.2

10.7

23.9

41.6

7.5

4.3

12.3

35.4

49.8

7.1

7.1

17.9

35.5

32.9

2.7

3.4

8.2

59.8

50.4

6.7

12.5

35.9

42.5

6.6

4.6

13.7

34.5

29.9

4.3

3.8

33.2

4.6

3.5c

10.3

23.8

48.9

6.7

12.9

40.7

47.9

6.7

4.6

19.2

38.2

37.6

5.1

3.1

7.2

46.1

483


GOLDEN GROWTH

Government revenue, percentage of GDP Total

Taxes

Individual income tax

Corporate income tax

Taxes on goods and services

2004–09a

2004–09a

2004–09a

2004–09a

2004–09a

Eastern partnership countries Armenia

23.7

17.1

1.9

2.6

9.4

Azerbaijan

27.3

16.7

1.4

7.4

6.4

Belarus

47.2

30.1

3.1

3.5

14.7

Georgia

29.3

24.4

6.2

2.9

13.9

Moldova

39.2

21.6

2.7

0.5

16.5

Ukraine

42.1

22.4

5.0

3.7

12.6

Australia

33.6

27.1

10.2

5.8

6.9

Canada

41.5

29.6

12.6

4.3

7.8

New Zealand

39.8

33.3

15.2

5.6

9.7

United States

31.2

17.5

8.1

1.7

4.3 11.6

North America and Oceania

East Asia China

26.6

18.6

1.2

3.6

Indonesia

18.4

12.3

4.2

1.0

5.9

Japan

33.0

16.3

7.3f

n.a.

2.6 7.0

Korea, Rep.

28.9

19.7

3.9

3.3

Malaysia

26.2d

18.8d

Philippines

14.1

12.3

1.6

3.4

5.2

Singapore

18.1

13.7

6.4f

n.a.

4.7

Taiwan, China

19.1

Thailand

20.4

16.4

2.0

5.1

8.0

Vietnam

25.1

21.5

0.5

7.7

9.7

Argentina

29.4

22.9

1.6

3.6

11.0

Brazil

35.6

22.9

2.5

4.5

13.5

Chile

22.0

17.0

5.7f

n.a.

10.1

Colombia

30.7

16.1

4.5

0.0

8.2

Mexico

12.8e

10.1e

Peru

18.7

14.1

1.5

3.8

6.9

Uruguay

29.5

18.9

2.6

2.7

12.0

Venezuela, RB

28.3

15.5

0.3

5.8

7.0 4.7

Latin America

Africa Algeria

36.3

34.3

1.8

2.7

Egypt, Arab Rep.

27.7

15.7

1.4

6.3

6.0

Morocco

35.2

25.0

3.6

6.0

10.8

South Africa

35.1

26.9

8.6

6.4

9.4

Tunisia

29.4

20.3

4.0

3.9

9.3

India

23.0

19.6

2.3

4.0

9.3

Russian Federation

52.4

22.7

4.3

3.4

6.7

Other

a. Data for the most recent available year. b. 2003. c. 2002.

484

d. 2001. e. 2000. f. Data include corporate income tax.

— = not available. n.a. = not applicable.


SELECTED INDICATORS

Government expenditure, percentage of GDP Total

Health

Education

Social protection

Public debt, percentage of GDP

2004–09a

2004–09a

2004–09a

2004–09a

2009

28.6

2.0

4.4

6.3

40.2

34.8

1.4

2.8

5.8

12.1

47.8

4.5

5.8

13.6

21.7

36.9

2.0

3.2

7.3

37.3

45.2

6.4

9.4

15.0

29.1

48.3

4.2

7.2

23.2

35.4

36.9

6.5

5.2

10.9

16.9

39.7

7.5

6.0

11.9

83.3

36.6

5.6

5.6

11.7

26.1

42.5

8.7

6.7

9.0

85.2

25.7

1.0

3.7

4.7

17.7

19.5

0.3

0.8

1.1

28.6

42.5

8.5

4.3

14.9

216.3

33.1

4.3

5.2

4.1

33.8

32.9

2.2

4.1

55.4

17.8

0.5

2.8

1.1

47.1

17.9

1.4

3.3

2.2

109.3

24.3

38.1

23.5

3.3

4.1

0.6d

44.3

33.4

2.8

5.3

2.7

51.2

37.9

6.3

5.4

9.2

58.7

38.7

4.1

5.1

13.1

68.1

26.4

3.8

4.0

7.6b

6.2

29.1

5.4

4.7

6.5

35.8

27.0

3.1

4.8

3.5c

44.7

20.7

2.7

2.5

3.9

27.1

32.3

4.7

2.8

10.1

61.0

26.1

1.9

4.5

2.0

32.7

41.7

5.0

4.3

8.7e

34.2

1.5

3.8

12.7

75.6

28.5

1.9

5.6

47.9

41.9

3.9

6.6

5.1

31.5

31.0

1.4

5.8

7.4

42.8

29.1

1.4

3.1

4.3

74.2

47.5

5.1

4.8

11.9

11.0

485


GOLDEN GROWTH

Sources and definitions Table A1. Basic indicators Indicator

Sources

Definitions

GNI per capita, US$

World Bank

Gross national income (GNI; formerly gross national product), per capita, expressed in current U.S. dollars. To smooth fluctuations in prices and exchange rates, the series is adjusted by the World Bankâ&#x20AC;&#x2122;s Atlas method.

GDP, per capita, PPP, international $

World Bank

Gross domestic product (GDP), per capita, adjusted by purchasing power parity (PPP). GDP per capita is converted to international dollars using PPP rates defined by the World Bank. The series is expressed in current international dollars.

GDP, PPP, international $, billions

World Bank

GDP, adjusted by PPP, expressed in billions of current international dollars.

Average growth of real GDP per capita, percent

World Bank

Average annual percentage growth rate of GDP per capita in constant local currency over 2000-10.

Population, total, thousands, 2010

U.S. Census

Total number of people living in a country in 2010. The data shown are midyear (that is, July 1 of the given year) estimates. The series is expressed in thousands.

Population, working age, percent, 2010

U.S. Census

Working-age population, expressed as a percentage of total population, in 2010. The working-age population is defined as people ages 15â&#x20AC;&#x201C;64.

Population, old age, percent, 2010

U.S. Census

Old-age population, as a percentage of total population, in 2010. Thebold-age population includes people ages 65 and older.

Population, total, thousands, 2050

U.S. Census

Total number of people living in a country in 2050, projected by the U.S. Census. The series is based on midyear estimates and expressed in thousands.

Population, working age, percent, 2050

U.S. Census

Working-age population in 2050, projected by the U.S. Census. The series is expressed as a percentage of total population.

Population, old age, percent, 2050

U.S. Census

Old-age population in 2050, projected by the U.S. Census, as a percentage of total population.

World Bank

Carbon dioxide (CO2) emissions stemming from the burning of fossil fuels and the manufacture of cement, consumption of solid, liquid, and gas fuels, and gas flaring. The amount is in metric tons, divided by population.

Sources

Definitions

CO2 emissions, metric tons per capita

Table A2. Trade Indicator

486

Exports, percentage of GDP, consumption goods

United Nations (UN); International Monetary Fund (IMF)

Exports, percentage of GDP, intermediate goods

UN; IMF

Exports of consumption goods to the rest of the world, as a percentage of GDP. The consumption goods include products in the following classification codes of Broad Economic Categories (BEC): 112, 122, 522, 61, 62, and 63. Exports of intermediate goods to the rest of the world, as a percentage of GDP. The intermediate goods include products in the following BEC classification codes: 111, 121, 21, 22, 31, 322, 42, and 53.


SELECTED INDICATORS

Indicator

Sources

Definitions

Exports, percentage of GDP, capital goods

UN; IMF

Exports of capital goods to the rest of the world, as a percentage of GDP. The capital goods contain those belonging to the following BEC classification codes: 41 and 521.

Exports, percentage of GDP, traditional services

IMF

Exports of traditional services to the rest of the world, as a percentage of GDP. The exports of traditional services consist of the sum of credits in the following categories of the fifth edition of the IMF Balance of Payments Manual (BPM5): 205, 236, 249, and 287.

Exports, percentage of GDP, modern services

IMF

Exports of modern services to the rest of the world, as a percentage of GDP. The exports of modern services contain credits of the following BPM5 codes: 245, 253, 260, 262, 266, and 268.

Imports, percentage of GDP, consumption goods

UN; IMF

Imports of consumption goods from the rest of the world, as a percentage of GDP.

Imports, percentage of GDP, intermediate goods

UN; IMF

Imports of intermediate goods from the rest of the world, as a percentage of GDP.

Imports, percentage of GDP, capital goods

UN; IMF

Imports of capital goods from the rest of the world, as a percentage of GDP.

Imports, percentage of GDP, traditional services

IMF

Imports of traditional services from the rest of the world, as a percentage of GDP. The imports of traditional services are the sum of debits in the same classification categories as in the exports (credits).

Imports, percentage of GDP, modern services

IMF

Imports of modern services from the rest of the world, as a percentage of GDP. The imports of modern services include debits of the same BPM5 items as in the exports (credits).

Table A3. Finance Indicator Private sector credit by domestic banks, percentage of GDP

Cross-border banking flows, percentage of GDP

Loan-to-deposit ratio, percent Foreign bank assets, percentage of total banking assets

Sources

Definitions

IMF

Domestic commercial banks’ claims on private sector, as a percentage of GDP. The main series is line 22D in the International Financial Statistics (IFS) by the IMF. If necessary, the series is extrapolated by line 22S (claims on other sector). GDP is also from the IMF.

Bank for International Settlements (BIS); IMF

External loans of BIS reporting banks vis-à-vis the non-bank sector in respective countries, as a percentage of GDP. The series shows amounts outstanding and is taken from Table 7B of BIS Locational Banking Statistics. GDP is from the IMF.

IMF

Domestic commercial banks’ credits to all sectors, divided by commercial banks’ deposits. The former is a sum of IFS lines 22A to 22S, and the latter comes from IFS lines 24 and 25.

Claessens and van Horen (2012)

Banking system assets held by foreign banks, as a percentage of total banking assets.

Foreign assets plus liabilities, percentage of GDP

Lane and MilesiFerretti (2007)

Total foreign assets and total foreign liabilities, as a percentage of GDP. It is a measure of financial integration.

Net debt, percentage of GDP

Lane and MilesiFerretti (2007)

Net debt is measured by a sum of international debt assets and foreign exchange reserves (excluding gold) minus international debt liabilities. The series on debt includes both portfolio debt plus other investment. GDP is also from the same source.

Current account balance, percentage of GDP

IMF

The sum of net exports of goods and services, net income, and net current transfers, as a percentage of GDP.

Capital flows, net, percentage of GDP, total

IMF

Net inflows of all types of capital, as a percentage of GDP.

487


GOLDEN GROWTH

Indicator

Sources

Definitions

Capital flows, net, percentage of GDP, FDI

IMF

Net inflows of foreign direct investment (FDI), as a percentage of GDP.

Capital flows, net, percentage of GDP, portfolio

IMF

Net inflows of portfolio investment, as a percentage of GDP. The series includes both public and private components.

Capital flows, net, percentage of GDP, other

IMF

Net inflows of other investment, as a percentage of GDP. The series includes both public and private components.

Table A4. Enterprise Indicator

488

Sources

Definitions

Labor productivity, constant 2005 US$, thousands, total, level, 1995

World Bank; International Labour Office (ILO 2010b); UN; country sources

Gross value added divided by employment in industry and services, expressed in thousands of constant U.S. dollars (price level as in 2005). The data refer to 1995, but if unavailable, the figures for the earliest available year after 1995 are shown. Industry and services are defined by the International Standard Industrial Classification of All Economic Activities (ISIC), Revision 3, and correspond to ISIC divisions 10–45 and 50–99, respectively. Due to the statistical reason, services also include any statistical discrepancies.

Labor productivity, constant 2005 US$, thousands, total, level, 2009

World Bank; ILO (2010b); UN; country sources

Gross value added divided by employment in industry and services, expressed in thousands of constant U.S. dollars (price level as in 2005). The data refer to 2009, but if unavailable, the figures for the most recent available year are shown.

Labor productivity, constant 2005 US$, thousands, total, CAGR, percent

World Bank; ILO (2010b); UN; country sources

Compound annual growth rate (CAGR) of gross value added divided by employment in industry and services. The rate of growth in labor productivity in industry and services is computed with the two constant price data defined above (1995 and 2009).

Labor productivity, constant 2005 US$, thousands, industry, level, 1995

World Bank; ILO (2010b); UN; country sources

Gross value added divided by employment in industry, expressed in thousands of constant U.S. dollars (price level as in 2005). The data refer to 1995, but if unavailable, the figures for the earliest available year after 1995 are shown. Industry includes ISIC divisions 10–45.

Labor productivity, constant 2005 US$, thousands, industry, level, 2009

World Bank; ILO (2010b); UN; country sources

Gross value added divided by employment in industry, expressed in thousands of constant U.S. dollars (price level as in 2005). The data refer to 2009, but if unavailable, the figures for the most recent available year are shown.

Labor productivity, constant 2005 US$, thousands, industry, CAGR, percent

World Bank; ILO (2010b); UN; country sources

CAGR of gross value added divided by employment in industry. The rate of growth in labor productivity in industry is computed with the two constant price data defined above (1995 and 2009).

Labor productivity, constant 2005 US$, thousands, services, level, 1995

World Bank; ILO (2010b); UN; country sources

Gross value added divided by employment in services, expressed in thousands of constant U.S. dollars (price level as in 2005). The data refer to 1995, but if unavailable, the figures for the earliest available year after 1995 are shown. Services correspond to ISIC divisions 50–99 and, due to the statistical reason, also include any statistical discrepancies.

Labor productivity, constant 2005 US$, thousands, services, level, 2009

World Bank; ILO (2010b); UN; country sources

Gross value added divided by employment in services, expressed in thousands of constant U.S. dollars (price level as in 2005). The data refer to 2009, but if unavailable, the figures for the most recent available year are shown.

Labor productivity, constant 2005 US$, thousands, services, CAGR, percent

World Bank; ILO (2010b); UN; country sources

CAGR of gross value added divided by employment in services. The rate of growth in labor productivity in services is computed with the two constant price data defined above (1995 and 2009).


SELECTED INDICATORS

Indicator

Doing Business, index 0–100, total

Doing Business, index 0–100, start-up

Doing Business, index 0–100, operations

Doing Business, index 0–100, institutions

Sources

Definitions

World Bank

The principal component of all Doing Business indicators, rescaled to range from 0 to 100, showing that higher the score, the better quality of overall business environment. The principal component analysis (PCA) is exercised using all countries over 2003–11 (that is, Doing Business 2004 to 2012).

World Bank

The principal component of Doing Business indicators in three areas related to business entry/exit. The score is rescaled to range from 0 to 100, indicating the higher the index, the better quality of regulation. The indicators are for starting a business, closing a business, and registering property. PCA is exercised using all countries over 2003–11 (that is, Doing Business 2004 to 2012).

World Bank

The principal component of Doing Business indicators in four areas related to business operations. The score is rescaled to range from 0 to 100 (higher, better). The indicators are for paying taxes, trading across borders, employing workers, and obtaining construction permits. PCA is exercised using all countries over 2003–11 (that is, Doing Business 2004 to 2012).

World Bank

The principal component of Doing Business indicators in three areas related to institutional environment. The score is rescaled to range from 0 to 100 (higher, better). The indicators are for protecting investors, getting credit, and enforcing contracts. PCA is exercised using all countries over 2003–11 (that is, Doing Business 2004 to 2012).

Table A5. Innovation Indicator Enrollment in doctorate level, per 1,000 population ages 25–34

Tertiary education attainment, percentage of population ages 30–34, IIASA/VID

Sources

Definitions

United Nations Educational, Scientific and Cultural Organization (UNESCO); U.S. Census

Enrollment in doctorate-level education, classified as the level 6 in the International Standard Classification of Education (ISCED), per thousands of population ages 25–34. The doctorate-level education includes both public and private institutions. The enrollment considers both male and female, and both full-time and part-time students.

World Bank

Percentage of population ages 30–34 with tertiary education, projected through the educational attainment model developed by the International Institute for Applied Systems Analysis (IIASA) and the Vienna Institute of Demography (VID), Austrian Academy of Sciences.

Tertiary education attainment, percentage of population ages 30–34, IUS

European Commission (2011)

The number of people ages 30–34 with some form of post-secondary education (ISCED 5 and 6), as a percentage of total population ages 30–34. For non-European countries, namely, Brazil, China, India, Japan, Russian Federation, and the United States, the age group refers to 25–64, instead of 30–34. The reference year varies by country but is 2008 or 2009, in most cases.

R&D expenditure, percentage of GDP, public

UNESCO; World Bank

All R&D expenditure, performed by government and higher education, as a percentage of GDP.

R&D expenditure, percentage of GDP, business

UNESCO; World Bank

All R&D expenditure, performed by enterprises, as a percentage of GDP.

Patent applications, per billions of GDP, PPP$

World Bank

Patent applications filed through the Patent Cooperation Treaty (PCT) procedure or with a national patent office, by both residents and nonresidents, per billions of GDP in international dollars.

489


GOLDEN GROWTH

Indicator Patent applications, per billions of GDP, PPS€

Sources

Definitions

European Commission (2011)

The number of patent applications filed under the PCT, at international phase, designating the European Patent Office, divided by billions of GDP in international euros adjusted by purchasing power standard (PPS). The reference year varies by country but is 2007, in most cases.

UN

Exports of medium- and high-tech products to the rest of the world, as a share of total exports in goods. The medium- and high-tech products include items in the following 38 classification codes of Standard International Trade Classification (SITC), Revision 3: 266, 267, 512, 513, 525, 533, 54, 553, 554, 562, 57, 58, 591, 593, 597, 598, 629, 653, 671, 672, 679, 71, 72, 731, 733, 737, 74, 751, 752, 759, 76, 77, 78, 79, 812, 87, 88, and 891.

Knowledge-intensive services exports, percentage of services exports

IMF

Exports of knowledge-intensive services to the rest of the world, as a share of total exports in services. The knowledge-intensive services exports contain credits of the following BPM5 codes: 245, 253, 260, 263, 272, 273, 850, and 851.

Royalties and license fees from abroad, percentage of GDP

IMF

Credit part of the international transactions in royalties and license fees, as a share of GDP. The code of the series is 266 in BPM5.

Medium- and high-tech product exports, percentage of goods exports

Public tertiary education spending, percentage of GDP

UNESCO

Total expenditure on tertiary educational institutions and administration, from public sources, as a percentage of GDP.

Table A6. Labor Indicator

Sources

Definitions

Labor force, total, thousands

ILO

The number of economically active population ages 15 and older, expressed in thousands. Economically active population includes both employed and unemployed people.

Labor force, change from 2010, younger, percent

ILO

Projected percentage change in the number of younger labor force ages 15–39, from 2010 to 2020.

Labor force, change from 2010, older, percent

ILO

Projected percentage change in the number of older labor force ages 40 and older, from 2010 to 2020.

Unemployment, percentage of labor force

World Bank

The number of labor force that is without work but available for and seeking employment, as a percentage of total labor force.

Net migration, per 1,000 population

World Bank

The number of immigrants minus the number of emigrants, including citizens and noncitizens, for the five-year period, expressed in thousands of population.

Emigration of tertiary educated, percentage of total tertiary educated

World Bank

Stock of emigrants ages 25 and older, residing in a country belonging to the Organisation for Economic Co-operation and Development (OECD) other than that in which they were born, with at least one year of tertiary education, as a percentage of population ages 25 and older with tertiary education.

Self-employment, percentage of total employment

ILO

Shadow economy, percentage of official GDP

490

Schneider, Buehn, and Montenegro (2010)

Minimum wage, international $, PPP

ILO (2010a)

Hiring and firing practices, index 1–7

Schwab (2011)

Self-employed workers, as a percentage of total employment. Selfemployed workers are defined as the sum of own-account workers and contributing family workers. Estimated shadow economy, as a percentage of official GDP. PPP-adjusted minimum wage, in international dollars. The index, ranging from 1 to 7, to assess the rigidity of hiring and firing of workers. The higher the index, the more flexible practices are (1 = impeded by regulations, 7 = flexibly determined by employers).


SELECTED INDICATORS

Table A7. Government Indicator

Sources

Definitions

Government revenue, percentage of GDP, total

IMF

General government total revenue, as a percentage of GDP. The main series is line 1 in the Government Finance Statistics (GFS) by the IMF. For Azerbaijan, Indonesia, Mexico, Uruguay, and Venezuela, RB, the numbers are for central government only.

Government revenue, percentage of GDP, taxes

IMF

General government total tax revenue, as a percentage of GDP. The main series is line 11 in GFS. For Azerbaijan, Indonesia, Mexico, Uruguay, and Venezuela, RB, the numbers are for central government only.

Government revenue, percentage of GDP, individual income tax

IMF

General government revenue from individual income tax, as a percentage of GDP. Line 1111 of the IMF GFS is used as the main series. For Azerbaijan, Indonesia, Uruguay, and Venezuela, RB, the numbers are for central government only.

Government revenue, percentage of GDP, corporate income tax

IMF

General government corporate tax revenue, as a percentage of GDP. GFS line 1112 is mainly used. For Azerbaijan, Indonesia, Uruguay, and Venezuela, RB, the numbers are for central government only.

Government revenue, percentage of GDP, taxes on goods and services

IMF

General government revenue from taxes on goods and services, as a percentage of GDP. The main series is line 114 in GFS. The taxes on goods and services include value-added taxes, sales taxes, excises, taxes on use of goods and on permission to use goods or perform activities (such as motor vehicle taxes), and so on. For Azerbaijan, Indonesia, Uruguay, and Venezuela, RB, the numbers are for central government only.

Government expenditure, percentage of GDP, total

IMF; OECD

Government expenditure, percentage of GDP, health

IMF; World Bank; OECD

General government expenditure on health, as a percentage of GDP. The main series is line 707 in GFS. For Indonesia, the Philippines, and Venezuela, RB, the numbers are for central government only.

Government expenditure, percentage of GDP, education

IMF; World Bank; OECD

General government expenditure on education, as a percentage of GDP. The main series is line 709 in GFS. For Indonesia, the Philippines, and Venezuela, RB, the numbers are for central government only.

Government expenditure, percentage of GDP, social protection

IMF; World Bank; Weigand and Grosh (2008); OECD

General government expenditure on social protection, as a percentage of GDP. The social protection includes pensions and social assistance of various kinds. The main series is line 710 in GFS. For Indonesia, the Philippines, and Venezuela, RB, the numbers are for central government only.

Public debt, percentage of GDP

IMF

General government total expenditure, as a percentage of GDP. Line 7 in GFS is used as the main data series. For Indonesia, the Philippines, and Venezuela, RB, the numbers are for central government only.

General government gross debt, as a percentage of GDP.

491


GOLDEN GROWTH

492


ABBREVIATIONS

Abbreviations BIS

Bank for International Settlements

BMU

German Federal Ministry for the Environment, Nature Conservation and Nuclear Safety

BOPS

Balance of Payments Statistics

CAP

Common Agricultural Policy

CO2

Carbon Dioxide

EBRD

European Bank for Reconstruction and Development

EC

European Commission

ECA

Europe and Central Asia

ECB

European Central Bank

EFTA

European Free Trade Association

EPL

Employment Protection Legislation

EU

European Union

FDI

Foreign Direct Investment

GDP

Gross Domestic Product

R&D

Research And Development

GFS

Government Finance Statistics

SME

ICRG

International Country Risk Guide

Small and Medium Enterprise

TFP

Total Factor Productivity

UN

United Nations

ICT

Information and Communication Technology

IFS

International Financial Statistics

UNCTAD United Nations Conference on Trade and Development

ILO

International Labour Office

UNEP

IMD

International Institute for Management Development

IMF

International Monetary Fund

IPTS

Institute for Prospective Technological Studies

IT

Information Technology

kWh

Kilowatt hour

LAC

Latin America and the Caribbean

OECD Organisation for Economic Cooperation and Development PPP

Purchasing Power Parity

United Nations Environment Programme

UNESCO United Nations Educational, Scientific and Cultural Organization WDI

World Development Indicators

WEF

World Economic Forum

WEO

World Economic Outlook

WGI

Worldwide Governance Indicators

WHO

World Health Organization

WTO

World Trade Organization

Key country groups (45 European Countries) The following are the country groups into which 45 European countries, on which this report focuses, are distinguished. These categories are broad and commonly used across all the chapters. In addition, each chapter has its own groupings of countries, and how the countries are classified is defined in each chapter. Eastern partnership countries

EU10

EU15

Armenia, Azerbaijan, Belarus, Georgia, Moldova, and Ukraine [sometimes, shown as “E. prtn.”]

Countries join the EU in 2004: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia

Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom

EFTA Iceland, Liechtenstein, Norway, and Switzerland EU candidate countries Albania, Bosnia and Herzegovina, Croatia, Kosovo, the former Yugoslav Republic of Macedonia, Montenegro, Serbia, and Turkey [sometimes, shown as “EU cand.”]

EU12 Countries joined the EU in 2004 or 2007: Bulgaria, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Romania, the Slovak Republic, and Slovenia

EU27 EU15 plus EU12

493


GOLDEN GROWTH

Country codes and names The 3-letter country codes used in this report are taken from the International Organization for Standardization (ISO) 3166-1 alpha-3 codes, except for a few countries, as described by the World Bank (data.worldbank.org/node/18). The use of the word countries to refer to economies implies no judgment by the authors and contributors about the legal or other status of a territory. The following are the codes and corresponding country names which can be found in the report.

494

Code

Name

Code

Name

ALB DZA ARG ARM AUS AUT AZE BLR BEL BIH BRA BGR CAN CHL CHN COL HRV CYP CZE DNK EST FIN FRA MKD GEO DEU GRC HKG HUN ISL IND IDN IRL ISR ITA JPN KAZ KOR

Albania Algeria Argentina Armenia Australia Austria Azerbaijan Belarus Belgium Bosnia and Herzegovina Brazil Bulgaria Canada Chile China Colombia Croatia Cyprus Czech Republic Denmark Estonia Finland France FYR Macedonia Georgia Germany Greece Hong Kong SAR, China Hungary Iceland India Indonesia Ireland Israel Italy Japan Kazakhstan Korea, Rep.

KSV KGZ LVA LIE LTU LUX MYS MLT MEX MCO MNE MDA MAR NLD NZL NOR POL PRT ROM RUS SRB YUG SGP SVK SVN ZAF ESP SWE CHE TJK THA TUN TUR TKM UKR GBR USA UZB

Kosovo Kyrgyz Republic Latvia Liechtenstein Lithuania Luxembourg Malaysia Malta Mexico Monaco Montenegro Moldova Morocco Netherlands New Zealand Norway Poland Portugal Romania Russian Federation Serbia Serbia and Montenegro Singapore Slovak Republic Slovenia South Africa Spain Sweden Switzerland Tajikistan Thailand Tunisia Turkey Turkmenistan Ukraine United Kingdom United States Uzbekistan


A REPORT BY THE EUROPE AND CENTRAL ASIA REGION OF THE WORLD BANK WITH CONTRIBUTIONS FROM BRUEGEL GOVERNMENT Are national governments in Europe too big? LABOR Is labor making Europe uncompetitive? INNOVATION Are Europe’s innovation fundamentals flawed? ENTERPRISE Are European enterprises overregulated? FINANCE Are capital flows in Europe excessive? TRADE Is Europe taking advantage of enlargement?

The World Bank 1818 H Street, NW Washington, DC 20433 USA Tel: (202) 473-1000

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